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

Ever wonder if a stock is trading at a fair price? The price-to-earnings ratio, or P/E ratio, is one of the most common indicators investors use to understand how a stock's price relates to the company's performance. It might sound technical, but this metric could help investors of all levels make more informed decisions when trading stocks. Here's how you can use P/E ratios to help spot potential opportunities and understand the market sentiment behind stocks and companies.

What is P/E ratio?

The price-to-earnings ratio, or P/E ratio, is a number that shows how much the market is willing to pay for $1 of the underlying company's earnings. It could help investors understand whether a stock is appropriately priced, given the company's performance, when compared to other similar companies in that same industry.

How does price-to-earnings ratio work?

Let's say XYZ company has a P/E ratio of 15. That means investors are willing to pay $15 for every $1 of XYZ's profit. In a vacuum, a company's P/E ratio may not mean much, but investors can contextualize the market sentiment for a specific stock by comparing its P/E ratio to its peers, the industry average, and the overall market.

Let's look at XYZ's P/E ratio again, but this time with the knowledge that the average P/E ratio for a company in the same sector is 20.

• A higher-than-average P/E ratio could indicate investors are expecting future growth from a company, but it can also suggest that a company is overvalued.
• A lower-than-average P/E ratio could mean investors are pessimistic about that company's future earnings compared to its peers. Alternatively, it might indicate the stock is undervalued.

Given XYZ's lower-than-average P/E ratio, a potential investor might be cautious to invest because of the current market sentiment. Or they might see potential value in XYZ's low valuation compared to its peers. It's always open to interpretation. To help you make that call, you could look at similar companies' financials—metrics such as their growth prospects and profit margins.

If XYZ's fundamentals are similar yet the P/E ratio is lower, it might be undervalued and a good buy if it fits into your investment plan. A drastically lower P/E ratio than XYZ's historical average over the past few years could suggest temporary pessimism or market overreaction, especially if the company's fundamentals haven't deteriorated significantly since its higher P/E ratio days. That could also mean it's undervalued.

P/E ratio formula

To calculate P/E ratio, you divide the current share price by the company's most recent earnings per share. The formula to calculate a stock's P/E ratio is:

Current share price / earnings per share (EPS) = P/E ratio

If a company's current share price is $20 and its most recent earnings per share is $2, the stock's P/E ratio is 10 (20 divided by 2).

Types of price-to-earnings ratios

Investors can use the standard current P/E ratio as a launching point to help them gauge a company's value. Here are some other common P/E ratio iterations and how investors use them.

• Forward price-to-earnings ratio considers a company's future estimated earnings in relation to its current stock price. Specifically, it's the average of analysts' published earnings estimates for the next 12 months divided by the current stock price. This could help investors make sense of the current price, considering what pros suspect may happen in the future.
• Trailing price-to-earnings ratio looks at a company's earnings performance over the previous 12 months. Accounting for the company's earnings history could help investors better understand the stock's current price—and where the price might go next, though past performance doesn't guarantee future results.
• Relative price-to-earnings ratio compares a company's P/E ratio to the average P/E ratio of its industry or the larger market. This metric could help investors contextualize a stock's current valuation with respect to its peers or to the market in general.

Advantages of P/E ratios

Investors frequently use P/E ratios as a valuation metric in part because of these 3 benefits:

1. They're a quick and easy benchmark. A stock's P/E ratio gives an at-a-glance view of a company's valuation without any financial modeling or complex math.
2. They offer some insight into market expectations. The P/E ratio can show how optimistic or cautious investors are about a company's future growth and earnings potential. In other words, it may or may not convey the investor sentiment about a specific stock.
3. They're helpful in comparing companies. It can be challenging to discern useful information from stock prices alone because they're not usually a one-for-one comparison. For instance, one company may have a lower stock price than another, but many more shares and therefore a higher valuation. That's not something share price shows. The P/E ratio, on the other hand, is more of an apples-to-apples comparison, because it's always based on $1 of a company's earnings.

Limitations of P/E ratios

Before using P/E ratios to make investment decisions, consider these drawbacks:

1. They don't tell the whole story. Although a company's P/E ratio can offer a quick assessment, this metric alone might not be enough to make an investing decision. It's important to dig deeper. Here's how to research stocks.
2. It's difficult to compare across industries. P/E ratios can vary greatly from one industry to the next. For example, in January 2025, the average PE ratio in the semiconductor industry was 64.15, according to New York University's Stern School of Business. Meanwhile, the average in the steel industry was 13.97.¹ Market sentiments can differ significantly from sector to sector, making P/E ratio a less-effective comparative tool.
3. They generally look backward. P/E ratios typically come from numbers from the past, since earnings are generally released quarterly. The further away you are from a company's last earnings report, the less accurate the P/E ratio may be as a valuation measure.

What is a good P/E ratio?

A good P/E ratio depends on many factors, including your own outlook on the company and how the industry and market at large are poised to perform. A high P/E ratio generally means that investors are expecting future growth from that company. They're willing to pay more today for a dollar of company profits because they expect more profit in the future. Depending on how you think this company's stock will perform, this could make it an attractive investment option—or a high P/E ratio could indicate the company is overpriced compared to its peers.

One way to tell, besides comparing the company's fundamentals to similar companies, is to look at whether the forward P/E ratio is higher than the trailing P/E ratio. That could suggest analysts expect earnings growth, and the market hasn't yet priced in future performance. If, on the other hand, the trailing P/E ratio is higher than the forward P/E ratio, the opposite could be true: The company could be overvalued, and you may not see near-term growth from this stock.

A low P/E ratio typically means investors are expecting slow or little growth in the future. But even if the market sentiment is negative, it could still present a buying opportunity, as a dollar of that company’s profits is selling at a discount, compared to its peers.