What is Price-to-Earnings (P/E) Ratio?
The price-to-earnings (P/E) ratio is a common formula for measuring the share value of a company compared to its earnings per share. Investors and analysts use this ratio to determine whether a company’s stock is overvalued or undervalued based on how much the company earns. The ratio shows exactly how much investors are willing to pay for every dollar the company makes.
The ratio can also be used to track a company’s earnings over time relative to its share price. It can be either forward or trailing. Forward-looking ratios consider how much the company expects to earn in the future, while backward-looking, or trailing ratios, rely on previously reported earnings. The ratio can also be applied to a major stock index to predict future changes in the business cycle.
Learn more about this important investment tool and how it works in the industry today.
What is the P/E ratio?
The P/E ratio is the current stock price of a company divided by the company’s earnings per share.
The P/E formula works as follows:
P is the current trading price of the stock. Stock prices are subject to change multiple times a day. You can find this number by checking a major stock index or by searching for a company online or a financial index, such as The Wall Street Journal.
The E part of the equation requires a little more legwork.
The E represents the company’s total earnings per share (EPS), which is the net income divided by the number of shares. There are two ways to find the EPS of a company. There is the Wall Street TTM, or trailing 12 months, which shows the company’s performance over the last 12 months.
You can also get the EPS directly from the company you’re trying to measure. Publicly traded companies are required to report their earnings every quarter. Most companies release information on EPS when they release their earnings report. This is what the company expects to make in the future.
The P/E ratio can be either trailing or forward-looking. The trailing P/E ratio compares the current share value to the company’s previously reported earnings. Investors can look at the most recent earnings report compared to the company’s historical record to see how the value of the stock has changed over time. The P/E 10 measures the current stock price compared to the company’s last 10 years’ worth of earnings, while the P/E 30 measures the current stock price compared to the company’s last 30 years’ worth of earnings.
If you use previously reported earnings data, or the P/E TTM, you will get the trailing E/P. If you are using an estimated EPS, you will get the forward P/E ratio.
An example of the P/E ratio in action:
Bank of America finished 2021 with a stock price of $30.31 per share and a diluted EPS of $1.87.
To calculate the P/E ratio, we divide 30.31 by 1.87, which gives us a ratio of 16.21x. This means that the company’s stock price is currently selling for around 16 times more than what the company earns per share. In other words, investors are willing to pay over $16 for every $1 that Bank of American earns.
P/E Ratio Meaning
Most stocks sell for more than the company’s earnings per share, which shows that investors are willing to pay more for the stock now compared to how much the company is earning. This may mean that investors expect the company’s earnings to increase or that the stock is overvalued. On the other hand, if the company has a low P/E ratio, it may mean that the company is undervalued or that investors expect the company’s earnings to drop in the future.
Investors can use the P/E ratio to compare the value of a company compared to its own historical record, one of its competitors, or a major stock index, such as the S&P 500. The ratio can be applied to any publicly traded company with earnings to report. If a company isn’t earning money, it won’t have a P/E ratio because there is no revenue to report.
Let’s continue with the Bank of America example above.
Identifying the company’s P/E ratio in isolation won’t give you much insight into whether the company’s stock is being overvalued or undervalued.
You can compare it to one of its competitors or the S&P 500 for more information.
For example, let’s take a look at JPMorgan Chase & Co. by comparison. JPM closed out 2021 with a stock price of $127.07 and a diluted EPS of $8.88.
Divide 127.07 by 8.88, and we get a P/E ratio of 14.31.
Meanwhile, the S&P 500 typically comes with a P/E of 15x trailing earnings.
This puts the Bank of America ratio into perspective. Suddenly, Bank of America’s stock price doesn’t seem so overvalued. It may have a slightly higher ratio because investors expect the company’s earnings to increase in the future compared to JPM.
Investors can also use the P/E ratio to examine the overall value of a major stock index, which compares the average trading price to the average earnings per share. This can be used to predict future changes in the business cycle. If the current P/E ratio for a major stock index is high compared to the historical average, this could mean that stocks are being overvalued and a recession is on the horizon.
For example, the P/E ratio for the S&P 500 has changed rapidly over time. It was as low as 5x in 1917 and went all the way up to 120x in 2009, right before the housing market crashed.
Problems with the P/E Ratio
Many investors and analysts use the P/E ratio to see if stocks are being overvalued or undervalued, but it’s best to use a combination of different ratios and formulas.
Every P/E ratio has its limitations.
For example, trailing P/E ratios show you how much the stock is trading for compared to the company’s previously reported earnings, but they won’t tell you how the company will fare in the future.
The other problem with trailing ratios is that publicly traded companies only report their earnings once a quarter, while stock prices can change consistently throughout the day. This means the trailing P/E ratio will fluctuate considerably.
Forward P/E ratios can also be unreliable. Namely, you must rely on the company’s estimated future earnings. Companies may underreport their estimated earnings so they can beat the P/E ratio on the next earnings report. Companies may also overreport their estimated earnings. Outside firms and analysts may offer their own assessments of the company’s future earnings, which could create confusion.
Is a high P/E ratio better?
Having a high P/E ratio isn’t necessarily a good thing. In some cases, this may mean that the stock is being overvalued, but it can also mean that investors expect the company’s earnings to rise more in the future compared to companies with low P/E stocks.
Companies with high P/E ratios may have a lot of buzz, but excessively high P/E ratios can also spell trouble in a particular industry. This could mean that a bubble is about to burst or that a recession is looming.
P/E vs. Earnings Yield
You can also calculate the opposite of the P/E ratio. This is what’s known as a company’s earnings yield, or the E/P ratio. It is the company’s EPS divided by its current share value, expressed as a percentage.
For example, Bank of America would have an E/P ratio of 6.1%. This shows you the rate of return on your investments. If you invested in Bank of America, you would get a rate of return of just 6.1%. But most investors are more concerned with growing their assets over time than how much they stand to earn when the company releases its earnings report, which is why the P/E ratio is more commonly used.
The P/E ratio is an important tool for measuring the value of a company’s stock relative to its earnings.