Price-earnings ratio (P/E ratio) definition

All you need to know about price-earnings ratios and how investors use them to make quality investment decisions.

  • By Glenn Fydenkevez,
  • U.S. News & World Report
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What is a price-earnings ratio?

A price-earnings ratio, or P/E ratio, is a simple numerical statement expressed as a ratio – sometimes called an earnings multiple – that shows the proportionate difference between a company's current share price and its earnings per share.

P/E ratios are key valuation measures used in the analysis of public company stocks. The most frequently quoted version of a P/E ratio is a company's current P/E ratio, also referred to as its "trailing P/E ratio." This figure is based on a company's actual "trailing" earnings that have been reported in quarterly financial statements. Trailing P/E ratios are dynamic numbers that change as the share price changes and when the company reports new earnings.

Analysts also compute and publish a set of P/E ratios called "forward P/E ratios." It's important to note that these are only estimates or predictions of future P/E ratios based on estimations of earnings that may or may not materialize. For this reason, forward P/E ratios are considered "estimated P/E ratios." Estimated P/E ratios are matters of fundamental analysis and analyst opinion and can be quite different for each analyst who follows the company.

How do P/E ratios work?

The P/E ratio is one of the simplest yet most fundamentally important valuation indicators in stock analysis. It's seen as an indicator of the relative value of a stock.

Companies with publicly traded stock shares are required to report their earnings quarterly. The four previous quarterly earnings reports combine to express earnings over the "trailing" 12 months and represent "annualized" earnings. Companies may also report annual earnings on a calendar basis or based on their fiscal year, which is the arbitrary one-year period they use for accounting purposes. Earnings are reported in absolute terms, or total earnings, on financial statements but also on a per-share basis. The per-share figure, called earnings per share or EPS, is the number used in calculating the P/E ratio.

The other component of a P/E ratio is the current stock price of the security in question. The prices of publicly traded companies are quoted continuously on exchanges whenever the stock market is open.

The formula for computing the P/E ratio is straightforward:

P/E ratio = share price ÷ EPS

In general terms, the lower the P/E ratio the more the stock is seen as a value stock. Conversely, a higher P/E ratio can indicate that a stock is more expensive and less of a bargain. The P/E ratio is, however, a subjective indicator. There are no empirically precise interpretations of a P/E ratio.

How do investors use P/E ratios?

Investors use P/E ratios to assess the relative value of a stock compared to industry peers and the market as a whole. P/E ratios are also used to predict where stock prices might go in the future. Analysts estimate a company's future EPS and apply a previously calculated estimated earnings multiple – the forward P/E ratio – to compute a hypothetical price target.

A stock's P/E ratio can easily be compared to other stocks in the same business or with other similar attributes. A P/E ratio of a single stock can also be judged against the average P/E ratio of an entire industrial sector or of a large market index, such as the Nasdaq (.IXIC) or the S&P 500 (.SPX). Side-by-side comparisons such as these are used as a yardstick to measure value and help people make investing decisions.

Conceptually, a lower P/E ratio equates to more value because it indicates a lower price for company earnings. A higher P/E ratio suggests the opposite: It's a more expensive stock because the cost of per-share earnings is higher. Smart investors, however, do not use P/E ratios as definitive measures of value and don't depend on earnings multiples alone when evaluating securities.

Many factors go into evaluating and interpreting a P/E ratio. Industry characteristics, historical trends, individual company fundamentals and market factors are all important considerations. The P/E ratio of a mature company in one industrial sector shouldn't be compared to a relatively new company in a different sector, for instance.

What is a good P/E ratio?

Though very valuable as an analytical tool, the P/E ratio is a subjective data point. P/E ratios cannot be labeled as good or bad on their own merits but must be thought of as just one part of the evaluation process.

A stock's P/E ratio will depend on several constantly changing factors. Average P/E ratios will vary from industry to industry and will differ according to the size and age of the company, its sector and several other factors. There can be no single determining element that makes a P/E ratio either good or bad.

A P/E ratio for a fast-growing technology company that only recently became public will be higher than that of a large tech company with products and services that are familiar to the investing public. Yet, they might both be considered "good" by Wall Street. This is because the smaller company has more opportunities to grow and will command a higher P/E ratio from investors who are willing to pay more today for superior earnings growth.

Pros of P/E ratios

  • Well established. The P/E ratio is central to fundamental equity analysis. Although it should not be depended on exclusively, it is valuable as a tool to assess current stock value and predict future price movement.
  • Ease of use. The concept of P/E ratios is easy to grasp by investors of any experience level.
  • Information-rich. A P/E ratio is one number that conveys a wealth of information. It can help investors determine whether a stock is undervalued or overvalued compared to its peers or the entire market. It can help predict possible future price increases or forecast potential decreases. It can also indicate the general market sentiment of investors toward a particular stock or a whole industry. Few investment statistics deliver so much valuable information.

Cons of P/E ratios

  • Not predictive. Just because a P/E ratio may signify that a stock is cheap does not mean that the stock will necessarily appreciate. Similarly, if a P/E ratio suggests a stock is overvalued, it does not follow that the stock price is bound to fall. Many factors contribute to the market price of a stock, and a P/E ratio is not determinative or indicative of price movements.
  • Perspective is necessary. To be used successfully in stock analysis, P/E ratios must be looked at in context. Historical trends, market factors, industry considerations, company size, management, products or services, and company growth prospects must all be considered.
  • Can change quickly. An abrupt change in stock price or an unexpected earnings announcement can change P/E ratios quickly and dramatically. Investors need to be ready to adjust expectations and manage decisions as P/E ratios change.
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