What is the price to earnings (P/E) ratio?

It’s a comparison of a stock’s share price with its issuing company’s annual earnings

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Everyone wants to generate a healthy return on their investments. As the saying goes, you should “buy low and sell high.” But while you may think it’s a good idea to invest in a downward-trending stock, there may be a reason for the stock’s decline.

Price-to-earnings (P/E) ratios help investors see if stock values are undervalued or overvalued. They can also tell you how a stock’s valuation compares to its industry or an index like the S&P 500. Consider checking out a stock’s P/E before investing.

Key insights

• The P/E ratio is a formula that evaluates the projected return of a stock by dividing the stock price by the earnings per share.
• There are different types of P/E ratios, like forward P/E, trailing P/E and Shiller P/E, which can offer unique insight into a stock’s price.
• Good P/E ratios vary by industry, with lower ratios potentially indicating undervalued stocks and higher ratios potentially indicating overvalued ones.
• P/E ratios are a starting point and should be contextualized with other financial metrics and insights.

P/E ratio meaning

A P/E ratio is the relationship between a company's stock price and earnings. E stands for “earnings,” and P stands for “price.” To calculate the P/E ratio, divide the price by the overall earnings per share (EPS).

For example, if a company’s stock is trading at \$30 per share and its earnings are \$5 a share, then the stock has a P/E of 6-to-1 (\$30 divided by \$5).

Or, if it’s trading at \$30 per share and earnings are \$10, the stock has a P/E of 3 (\$30 divided by \$10).

But what if a stock goes up (or down) in value? Consistent earnings, excitement or anticipation of an increase in the company’s industry can all impact price (and the opposite is also true).

If the \$30 stock rises to \$40 per share and the EPS stays the same (\$10), the P/E ratio rises from 3 to 4. Instead of paying \$3 for every \$1 of investor earnings, investors are now willing to pay \$4 for every \$1.

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How to calculate P/E ratio

To calculate a P/E ratio, you’ll need to find the price and earnings for the stock you want to buy.

To calculate the P/E ratio, divide the price by the overall earnings per share.

You can find a company’s earnings in its earnings report. This is also where you can find the company’s best-educated guess of what it's expected to earn in the future. You can find the “P” part of the equation by looking up the stock’s ticker symbol on any financial website.

For example, on Sept. 14, 2023, Apple’s share price was \$174.21. Apple’s EPS for the last 12 months was \$5.95, making its P/E ratio 29.28.

Apple is a great example of a best-case scenario for P/E ratios. The company has consistently grown its earnings over time, and investors are regularly enthusiastic about the company’s long-term performance potential.

P/E ratio variations

Once you’ve calculated the P/E ratio, you have part of the company’s story. To get a better understanding of the full story, look at the forward P/E, trailing P/E or Shiller P/E.

For example, on Sept. 14, 2023, Google’s parent company, Alphabet, had an EPS of \$4.76 and a stock price of \$136.71, giving it a P/E of 28.72. Here’s how its P/E ratio can change based on which type you use:

Forward P/Es predict the future earnings of a stock by estimating future earnings. This gives investors a rough idea of what the company’s returns could be in the future.

Yet, forward P/Es aren’t exact. Companies could underestimate their earnings to beat their estimated P/E in the next quarter. Or, they could overstate their earnings and adjust that number at the next quarterly earnings announcement.

Alphabet’s forward ratio as of Sept. 14, 2023, was 20.39 — likely due to uncertainty in the market at that time.

Trailing P/E ratio
Trailing P/Es use trailing 12 months (TTM) as historical data to gather a P/E ratio. To calculate the trailing P/E, divide the current share price (P) by the total EPS over the last 12 months. Trailing P/Es tend to be more popular than forward P/Es because the metrics are more objective.

Yet, past performance doesn’t always signal future behavior. While companies release earnings each quarter, that isn’t nimble enough to account for daily stock fluctuations. Major company events could drive stock prices significantly higher or lower. Trailing P/Es can’t predict these trends.

Alphabet’s EPS average from June 2022 to June 2023 was \$4.72. Since it was trading at \$136.71 at the time of this writing, its trailing P/E was 28.96.

Shiller P/E ratio
Also known as a CAPE ratio, the Shiller ratio is the current market price divided by the inflation-adjusted earnings based on a 10-year average. While less popular than trailing or forward P/Es, Shiller ratios eliminate the fluctuation that can skew corporate earnings.

Alphabet’s Shiller P/E ratio was 46.19 based on a \$136.71 share price and an average EPS of \$2.96 over the last 10 years.

To sum up a stock’s performance, consider all three. In our example, the Shiller ratio offers the perspective that Alphabet has previously been a profitable stock, with a P/E ratio of 46.19. The trailing and forward-leading stock offer more conservative P/E ratios of 28.96 and 20.39, respectively. Together, these P/E ratios give a more well-rounded view of the stock’s past and potential future returns.

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What is a good P/E ratio?

There’s a lot that goes into determining what is and isn’t a good investment. A good or bad ratio depends on the industry. To determine the P/E rating of an industry, compare at least three competitors in the industry to find an average. Then, compare the company’s current P/E ratio to its historical data.

Normally it’s better to have a lower P/E because you’ll pay less for every dollar of earnings you receive, but that depends on the reason behind the lower P/E. Low P/Es aren’t always a bargain. They can indicate that the company:

• Is undervalued
• Is doing exceptionally well compared with past earnings
• Is a “value trap” or doesn’t have great future earning potential

Higher P/Es suggest investors are expecting higher earnings growth. But a high P/E doesn’t take into account if a company is quickly growing, which would bring the P/E ratio down. Plus, high P/Es could be a reflection of a successful stock, or it could just be overvalued. Hot stocks can trade at a P/E of 50 or more but normally eventually drop.

“Whether a ratio is good or bad depends on the context, such as the company’s industry, growth potential and overall market condition,” said Nate Nead, managing principal and licensed investment banker at InvestNet.

If a company has no earnings or is losing money, it is ascribed a 0 or N/A ratio.

P/E ratio examples

Amazon, Tesla and Microsoft all operate in different industries. As of Sept. 14, 2023, their P/E ratios were:

• Amazon: 114.06 (\$144.85 divided by \$1.27)
• Tesla: 70.06 (\$276.04 divided by \$3.94)
• Microsoft: 34.21 (\$338.70 divided by \$9.90)

While there is a wide range in P/E ratio, each could be considered a “good” or “bad” ratio based on the average P/E ratio of their respective industries.

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How to use P/E ratio

If you want to use a P/E ratio to determine whether a stock is a worthwhile investment, compare the prices of similar stock companies. Examine if the stock you’re considering is undervalued, appropriately priced or overvalued. The P/E ratio can then inform if you should buy, sell or hold.

Keep in mind the limitations of a P/E ratio before investing:

• Debt is not included in a P/E ratio. A business with a higher debt may have a lower P/E, but if business is good, the higher debt could yield higher earnings thanks to investment risks paying off.
• P/E ratios don’t reflect rapid growth. This can make a stock undervalued at first and overvalued over time.
• Although it is difficult to do, P/E ratios can be manipulated by companies or external influences.
• P/E ratios aren’t able to take into account external factors like industry recessions or strenuous situations.

“The power of using ratios to analyze investments is that they’re quick and easy to use, but they’re only a starting point,” said Ryan Graves, a financial advisor and president of Bemiston Asset Management. “Whether the ratio is good or bad can depend on the overall market valuation or its valuation relative to its peers within an industry.”

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FAQ

What does the price-to-earnings ratio tell us?

The P/E ratio tells us what stock market investors are willing to pay today for stocks based on a company’s earnings (E) and price (P). Each additional dollar in a P/E ratio indicates an additional dollar investors are willing to spend for a dollar of investment earnings.

What is an average P/E ratio?

The average market P/E ratio has historically been between 15 and 25. But the average can vary based on the industry. For example, a P/E ratio of 20 might be average in one industry but considered low in another. An average P/E ratio provides a general benchmark for assessing whether a stock is overvalued or undervalued based on historical or industry norms.

What does a high P/E ratio mean?

Generally, a high P/E ratio means that the stock is higher than similar stocks in the industry. When investing in a high P/E stock, investors spend more money for each dollar of the company's earnings. However, the stock could be overvalued.

What does a low P/E ratio mean?

A low P/E ratio means that the stock is lower than similar stocks in the industry, so investors spend less money on each dollar of the company’s earnings. The stock could be undervalued or headed in a downward trend.

Why is the P/E ratio important?

P/E ratios are important because they help determine if a stock is undervalued or overvalued. Keep in mind that the P/E ratio tells investors only part of the story, and additional research is often needed.

Bottom line

You can use P/E ratios as a starting point to assess the possibilities of a stock before investing. Remember, though, that the P/E ratio doesn’t tell the whole story, and there are many factors, from company debt to industry shifts, that can affect a stock’s performance.

Investing in the stock market can help you build wealth over time, but it can also be risky. Be sure to research your investments thoroughly and think long-term.

Article sources
ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
1. Charles Schwab, “ The Price You Pay: A Look at Equity Valuations .” Accessed Sept. 18, 2023.
2. Stanford University, “ Notes on P/E Ratios .” Accessed Sept. 28, 2023.