The price-to-earnings (P/E) ratio is calculated by dividing a company’s stock price per share by its earnings per share (EPS), giving investors an idea of whether a stock is under- or overvalued. A high P/E ratio may suggest that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. The P/E ratio indicates the dollar amount an investor can expect to invest in a company so that they may receive one dollar of that company’s earnings. While the P/E ratio is a useful stock valuation measure, it can be misleading to investors.
Key Takeaways
- The P/E ratio indicates to investors whether a company's stock is realistically valued.
- A high P/E ratio may suggest that investors are expecting higher earnings in the future.
- The P/E ratio can be misleading because it is either based on past data or projected future data (neither of which are reliable) or possibly manipulated accounting data.
The Price-To-Earnings Ratio Can Mislead Investors
One reason why the P/E ratio is considered misleading for investors is that it is based on past data (as is the case with trailing P/E) and does not guarantee that earnings will remain the same. Similarly, if the P/E ratio is based on projected earnings (for example, with a forward P/E), there is no guarantee that estimates will be accurate. Additionally, accounting techniques can control (or manipulate) financial reports.
The different ways of accounting mean that EPS can be skewed depending on the accounting methods. Skewed EPS data make it difficult for investors to accurately value a single company or compare various companies since it is impossible to know if they are comparing similar figures.
There's More Than One Way to Calculate EPS
Another problem is that there is more than one way to calculate EPS. In the P/E ratio calculation, the stock price per share is set by the market. The EPS value, however, varies depending on the earnings data used. For example, whether the data is from the past 12 months or estimates for the coming year, analysts can use earnings estimates to determine the relative value of a company at a future level of earnings—a value known as the forward P/E.
Comparing one company’s P/E ratio based on trailing earnings to another’s forward earnings creates an apples-to-oranges comparison that can be misleading to investors. For these reasons, investors would be wise to use more than the P/E ratio when evaluating a company or comparing various companies.
The P/E ratio is calculated using earnings per share, but EPS can be skewed depending on the accounting methods. Skewed EPS data makes it impossible to compare one company with another.
A primary limitation of using P/E ratios becomes evident when investors compare the P/E ratios of different companies. Valuations and business models may vary wildly across sectors, and it is best to use P/E as a comparative tool for stocks within the same sector rather than multiple sectors.
An Example of a P/E Ratio Comparison Between Stocks
A quick look at P/E ratios for Apple (AAPL) and Amazon (AMZN) illustrates the dangers of using only the P/E ratio to evaluate a company. In mid-December, 2018, Apple traded at $165.48 with a P/E ratio (TTM) of 13.89. On the same day, Amazon’s stock price was $1,591.91 with a P/E ratio of 89.19. One of the reasons Amazon’s P/E is so much higher than Apple's is that its efforts to expand aggressively on a wide scale have helped keep earnings somewhat suppressed and the P/E ratio high.
The P/E ratio should be used with a variety of other analysis tools to analyze a stock.
If these two stocks were compared based on P/E alone, it would be impossible to make a reasonable evaluation. A low P/E ratio does not automatically mean a stock is undervalued. Similarly, a high P/E ratio does not necessarily mean a company is overvalued.
FAQs
A high P/E ratio may suggest that investors are expecting higher earnings in the future. The P/E ratio can be misleading because it is either based on past data or projected future data (neither of which are reliable) or possibly manipulated accounting data.
What is the problem with price earnings ratio? ›
The biggest limitation of the P/E ratio: It tells investors next to nothing about the company's EPS growth prospects. If the company is growing quickly, you will be comfortable buying it even it had a high P/E ratio, knowing that growth in EPS will bring the P/E back down to a lower level.
What may be a problem of comparing the PE ratio? ›
The P/E ratio fluctuates from one firm to another. A company's standard P/E ratio will differ from another company's P/E ratio. As a result, the P/E of a stock cannot be compared to the P/E of the overall market since the P/E of the overall market includes diverse sectors of firms with their respective P/E.
Why is price to earnings ratio important to investors? ›
Why Is the P/E Ratio Important? The P/E ratio helps investors determine whether the stock of a company is overvalued or undervalued compared to its earnings.
What does the price to earnings ratio PE tell you? ›
Price to Earnings Ratio or Price to Earnings Multiple is the ratio of share price of a stock to its earnings per share (EPS). PE ratio is one of the most popular valuation metric of stocks. It provides indication whether a stock at its current market price is expensive or cheap.
How can PE ratio be manipulated? ›
A high P/E ratio may suggest that investors are expecting higher earnings in the future. The P/E ratio can be misleading because it is either based on past data or projected future data (neither of which are reliable) or possibly manipulated accounting data.
What factors affect price-earnings ratio? ›
P/E ratio is affected by several factors some of the common factors are - earnings and sales growth of the firm, the risk (or volatility in performance), the debt-equity structure of the firm, the dividend policy, and the quality of management.
Why is it bad to have a high PE ratio? ›
A high ratio means the stock is overvalued. However, a high ratio often signifies that it is a growth stock, meaning there is a chance of high future performance, even if the cost per share is high at the moment. However, growth stocks are also volatile, meaning they can be risky investments.
Why would a PE ratio be negative? ›
A negative P/E ratio means the company has negative earnings or is losing money. Even the most established companies experience down periods, which may be due to environmental factors that are out of the company's control.
How do you know if PE ratio is overvalued? ›
A high P/E ratio for a fast-growing company may make a lot of sense, so it's important to understand the growth outlook before making a judgment solely based on the P/E ratio. A PEG ratio above 2 is typically considered expensive, while a ratio below 1 may indicate a good deal.
To give you some sense of what average for the market is, though, many value investors would refer to 20 to 25 as the average P/E ratio range. And again, like golf, the lower the P/E ratio a company has, the better an investment the metric is saying it is.
What does a high PE ratio tend to indicate that a company will? ›
High P/E. Companies with a high Price Earnings Ratio are often considered to be growth stocks. This indicates a positive future performance, and investors have higher expectations for future earnings growth and are willing to pay more for them.
Do you want a high price-to-earnings ratio? ›
Most of the P/E ratios you see for publicly-traded stocks are an expression of the stock's current price compared with its previous 12 months of earnings. Stocks with high price-to-earning (P/E) ratios can be overpriced.
What is the PE ratio of the stock market today? ›
The current S&P500 10-year P/E Ratio is 28.7.
What are the limitations of using the PE ratio as a measure of value? ›
While the P/E Ratio is a useful tool, there are some limitations to consider. These include not taking into account future earnings or the company's debt load and only providing limited insight into the overall value of a company.
What could increase a company's price to earnings ratio? ›
Growth in earnings and sales
This is one of the primary factors driving P/E ratios of stocks. Markets always prefer companies that are able to grow their top-line and their bottom line at a rapid pace. This could be newer markets or due to greater penetration of existing markets.
Why does PE ratio matter? ›
Surely, the P-E ratio is the most common way to gauge a stock's valuation, i.e., how its share price compares with the company's earnings. Usually, the share price is divided by the trailing 12 months of earnings per share. The idea is that the lower the ratio, the more attractive the stock is.
Does a negative PE ratio mean the stock is undervalued? ›
A negative P/E ratio indicates that the stock may be undervalued or that there is an oversupply of the stock in the market which is causing investors to lose confidence. It is important to investigate further before making any decisions about investing in such a situation.
Which is better undervalued or overvalued? ›
Generally, undervalued shares are favored over overvalued ones, as the investors buy low and sell high. If the company is performing well, it can give promising returns. Buying an overvalued share doesn't have this advantage, as the price returns to its intrinsic value, which is lower.
How do you tell if a company is undervalued or overvalued? ›
P/E ratio. The price-to-earnings (P/E) ratio is one of the most widely used ratios in investment analysis. It compares a company's stock price to its earnings per share and is a way for investors to know how much they're getting in earnings power relative to the price they're paying for the stock.
Under normal circ*mstances, the market capitalization is almost equal to the GDP. If this ratio falls below 0.7 or so, it could mean that the market is undervalued and could provide a buying opportunity. On the other hand, if this ratio crosses above 1.25, the market is said to be overvalued.
What does PE ratio tell an investor about a stock? ›
The P/E ratio helps investors determine the market value of a stock as compared to the company's earnings. In short, the P/E shows what the market is willing to pay today for a stock based on its past or future earnings.
Is high PE ratio good for investors? ›
Is a High PE Ratio Good or Bad? If you were wondering “Is a high PE ratio good?”, the short answer is “no”. The higher the P/E ratio, the more you are paying for each dollar of earnings. This makes a high PE ratio bad for investors, strictly from a price to earnings perspective.
Why might an investor buy a company with a high PE ratio? ›
If investors are excited about the prospects for a given company, they may be willing to accept a higher P/E ratio in order to buy its shares. On the other end of the spectrum, if investors feel that future earnings will be underwhelming, a stock's P/E ratio may languish at a relatively low level.
Do you want earnings per share to be high or low? ›
In general, higher EPS is better but one has to consider the number of shares outstanding, the potential for share dilution, and earnings trends over time.
What is a good PE ratio for value investing? ›
The P/E ratio is often used by value investors as a basic screen. It is price of the stock divided by earnings. The cheaper it is, the better. Most value investors look for a P/E of 15 or less.
What are the best PE ratio stocks? ›
Sectors
| Company | CMP (Rs) | P/E (x) |
|---|
| BAJAJ HOLDINGS & INVESTMENT | 6,873.7 | 274.0 |
| TRENT | 1,486.4 | 170.3 |
| ADANI TOTAL GAS | 818.4 | 170.1 |
| ADANI GREEN ENERGY | 896.0 | 155.3 |
21 more rowsIn order to determine whether he could pursue or ignore a company, Buffett would find the P/E and the book value. He would focus on a business with a P/E of 15 or lower.
Is a high price-earnings ratio good or bad? ›
A high ratio means the stock is overvalued. However, a high ratio often signifies that it is a growth stock, meaning there is a chance of high future performance, even if the cost per share is high at the moment. However, growth stocks are also volatile, meaning they can be risky investments.
Does PE ratio really matter? ›
P/E ratio, or price-to-earnings ratio, is a quick way to see if a stock is undervalued or overvalued. And so generally speaking, the lower the P/E ratio is, the better it is for both the business and potential investors. The metric is the stock price of a company divided by its earnings per share.
A negative P/E ratio means the company has negative earnings or is losing money. Even the most established companies experience down periods, which may be due to environmental factors that are out of the company's control.
Is price-earnings ratio good? ›
Companies with a high Price Earnings Ratio are often considered to be growth stocks. This indicates a positive future performance, and investors have higher expectations for future earnings growth and are willing to pay more for them.
What does a higher price earnings ratio generally mean? ›
Generally a high P/E ratio means that investors are anticipating higher growth in the future. The average market P/E ratio is 20-25 times earnings.
Why is Amazon PE ratio so high? ›
Analysts estimate Amazon to grow at 10-15%, hardly deserving of a 76 multiple of earnings. But if we take a closer look, we can see that Amazon has always had a high P/E ratio, and with good reason, because it emphasizes free cash flow over earnings, at times even purposely reducing earnings to pay less taxes.
