The price-to-earnings (P/E) ratio is a fundamental financial metric that measures a company’s current share price relative to its earnings per share (EPS). It’s a widely used tool for assessing the relative value of a company’s stock, often referred to as the price multiple or earnings multiple. Investors use the P/E ratio to compare a company’s valuation to its historical performance, against other companies within the same industry, or against the overall market. Understanding What Is P/e Ratio is crucial for making informed investment decisions.
Key Takeaways
- The price-to-earnings (P/E) ratio reflects the amount investors are willing to pay for each dollar of a company’s earnings.
- A high P/E ratio can indicate that a company’s stock is overvalued or that investors anticipate high growth in the future.
- Companies with no earnings or losses do not have a P/E ratio, as the denominator (EPS) cannot be zero or negative.
- Trailing P/E and forward P/E are the two most common types of P/E ratios.
- P/E ratios are most effective when comparing companies in the same industry or when analyzing a single company’s performance over time.
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Diving Deeper into What is P/E Ratio
The P/E ratio is a cornerstone of stock valuation used by investors and analysts globally. It helps in determining whether a stock is overvalued, undervalued, or fairly priced. A company’s P/E can be benchmarked against competitors in the same sector or against broader market indices like the S&P 500.
For those focused on long-term trends, metrics like P/E 10 or P/E 30, which average earnings over the past 10 or 30 years, can be particularly insightful. These longer-term averages help smooth out fluctuations caused by short-term economic cycles, offering a clearer picture of a stock index’s overall value.
Historically, the S&P 500’s P/E ratio has fluctuated significantly, from a low of around 6 in mid-1949 to a high of 122 in mid-2009 following the financial crisis. As of April 2024, the S&P 500’s P/E ratio was 26.26.
The P/E Ratio Formula and Calculation Explained
The P/E ratio is calculated using a simple formula:
P/E Ratio = Market Value per Share / Earnings per ShareTo calculate the P/E ratio, you divide the current market price of a stock by its earnings per share (EPS).
The stock price (P) is readily available on financial websites. However, the EPS component can be derived from different sources, leading to variations in the P/E ratio.
EPS is commonly reported in two forms: Trailing Twelve Months (TTM), which reflects the company’s performance over the past year, and earnings guidance, which represents the company’s projected future earnings. These different EPS figures form the basis for trailing and forward P/E ratios, respectively.
When is the Best Time to Evaluate the P/E Ratio?
Analysts and investors routinely examine a company’s P/E ratio to assess whether the current share price accurately reflects the company’s projected earnings per share. This analysis is crucial for identifying potential investment opportunities and making informed decisions.
Forward Price-to-Earnings (P/E)
Forward P/E, also known as leading P/E or “estimated price to earnings,” uses future earnings guidance rather than historical data. This forward-looking indicator compares current earnings to anticipated future earnings, offering insights into potential earnings without accounting adjustments.
However, forward P/E has limitations. Companies may underestimate earnings to surpass estimated P/E when actual earnings are reported. Additionally, external analysts’ estimates can vary from company estimates, leading to confusion.
Trailing Price-to-Earnings (P/E)
Trailing P/E is calculated by dividing the current share price by the total EPS for the previous 12 months. It’s the most popular P/E metric because it uses actual, reported earnings data, making it objective.
However, trailing P/E also has shortcomings. A company’s past performance doesn’t necessarily predict future earnings. Investors base purchases on potential earnings, not historical performance. Since stock prices fluctuate constantly, a fixed EPS figure may not accurately reflect the company’s current valuation or potential.
When the forward P/E ratio is lower than the trailing P/E ratio, analysts expect earnings to increase. Conversely, if the forward P/E is higher, analysts anticipate a decline in earnings.
Valuation Insights from P/E
Beyond indicating whether a stock is overvalued or undervalued, the P/E ratio reveals how a stock’s value compares with its industry or benchmarks like the S&P 500.
The P/E ratio represents the dollar amount an investor is willing to invest in a company to receive $1 of its earnings. If a company trades at a P/E multiple of 20x, investors pay $20 for $1 of current earnings.
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Real-World Examples of P/E Ratio
Consider FedEx Corporation (FDX), with a stock price of $242.62 and an EPS of $16.85. Its P/E ratio is:
$242.62 / $16.85 = 14.40
Comparing Companies Using P/E
Comparing Hess Corporation (HES) and Marathon Petroleum Corporation (MPC) illustrates P/E’s comparative value.
Hess Corporation (HES):
- Stock price: $142.07
- Diluted 12 months trailing EPS: $4.49
- P/E: 31.64 ($142.07 / $4.49)
Marathon Petroleum Corporation (MPC):
- Stock price: $169.97
- Diluted 12 months trailing EPS: $23.64
- P/E: 7.19
HES’s P/E of 31, compared to MPC’s 7, suggests HES might be overvalued or that investors expect higher earnings growth.
Investor Expectations and P/E
A high P/E often indicates expectations of higher earnings growth, while a low P/E may suggest undervaluation or exceptional performance. A P/E ratio of N/A signifies that a company has no earnings or is posting losses.
P/E vs. Earnings Yield
The earnings yield, the inverse of the P/E ratio, is the EPS divided by the stock price, expressed as a percentage. It’s useful when concerned about return on investment.
P/E vs. PEG Ratio
The price/earnings-to-growth (PEG) ratio measures the relationship between the P/E ratio and earnings growth, providing a more complete picture. A PEG ratio less than one typically suggests undervaluation.
Absolute vs. Relative P/E
Absolute P/E represents the P/E of the current period, while relative P/E compares the absolute P/E to a benchmark or a range of past P/Es.
Limitations of Using the P/E Ratio
The P/E ratio has limitations. It’s challenging to calculate for unprofitable companies and can’t be used effectively to compare companies from different sectors.
Other P/E Considerations
Debt can skew P/E ratios, and the accuracy of earnings information is critical.
Alternatives to P/E Ratios
Alternatives include the price-to-book (P/B) ratio, price-to-sales (P/S) ratio, and enterprise value-to-EBITDA (EV/EBITDA) ratio.
What Is a Good Price-to-Earnings Ratio?
The answer depends on the industry. Some industries tend to have higher average price-to-earnings ratios. To get a general idea of whether a particular P/E ratio is high or low, compare it to the average P/E of others in its sector, then other sectors and the market.
Is It Better to Have a Higher or Lower P/E Ratio?
Many investors say buying shares in companies with a lower P/E ratio is better because you are paying less for every dollar of earnings.
What Does a P/E Ratio of 15 Mean?
A P/E ratio of 15 means that the company’s current market value equals 15 times its annual earnings.
What Is the Difference Between Forward P/E and Trailing P/E?
The trailing P/E ratio uses earnings per share from the past 12 months, reflecting historical performance. In contrast, the forward P/E ratio uses projected earnings for the next 12 months, incorporating future expectations.
What Are the Limitations of the P/E Ratio?
The P/E ratio has several limitations. It doesn’t account for future earnings growth, can be influenced by accounting practices, and may not be comparable across different industries.
The Bottom Line
The P/E ratio is a fundamental financial metric for evaluating companies, indicating investor expectations and helping to determine if a stock is overvalued or undervalued. However, it should be used with other financial measures.
