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When you buy stock, you’re essentially buying a tiny piece of the company it represents. Understanding how profitable the company is in relation to its stock price can be an important consideration for investors.
The definition of the price-to-earnings ratio, usually called a P/E ratio, is the ratio between the price of the company’s stock and the company’s earnings per share. Investors can use P/E ratios to find affordable stocks.
Price-Earnings Ratio
The P/E ratio is a metric used for comparison, so a particular company’s P/E ratio doesn’t tell you much unless you compare it to its historical ratios or the ratios of competing companies. And even then, it doesn’t tell you what the stock is worth, per se. Rather, it suggests what the market thinks the stock is worth.
When you look at a company’s stock valuation statistics on a financial site such as Yahoo Finance, you’ll typically see two P/E ratios listed: forward and trailing.
Forward P/E Ratio
The forward P/E ratio is based on estimates of future earnings for the coming 12 months. Knowing the forward P/E ratio is helpful to investors because it tells you what kind of earnings the company expects over the next year.
However, companies may change their earnings estimates quarter by quarter, so a given forward P/E ratio may not be accurate.
Trailing P/E Ratio
The trailing P/E ratio, on the other hand, is based on actual earnings over the last 12 months. Because the calculation uses historical earnings performance, the trailing P/E — when compared to the ratios of similar companies and the stock’s own ratio over time — can paint a more accurate picture of a company’s current valuation.
How To Calculate P/E Ratio
You find a trailing P/E ratio by dividing a stock’s share price by the earnings per share, or EPS, which is simply the total net profits from the last year divided by the total number of outstanding shares.
Share prices change moment by moment, and companies release new earnings figures every three months. As a result, a company’s trailing P/E ratio will change constantly.
Trailing P/E Ratio Example
If a company has a share price of $20 and an EPS of $0.50, that would give it a P/E ratio of 40, meaning the stock is trading at 40 times its earnings per share.
Looking at it simply, the number in a P/E ratio tells you how much you have to pay to get one dollar of underlying company profits. If a company has a share price of $20 and an EPS of $0.50, you need to spend $40 to get the equivalent of one dollar of earnings — two shares.
Forward P/E Ratio Calculation
Analysts calculate a forward P/E ratio by dividing the stock’s share price by estimated future earnings.
What Is a Good P/E Ratio?
A P/E ratio above zero means a company is profitable. Generally speaking, P/E ratios below 15 are considered low, and ratios above 50 are considered high. But is a high P/E ratio good? A lower P/E ratio is typically better because it means you’re getting more bang for your buck, but there are many different factors to consider besides the ratio itself.
How To Tell If a P/E Ratio Is Good
Different industries have different standards for what constitutes a good P/E ratio, and the size or age of a company can also play a major role in how the market will view a company’s ratio of price to earnings. If you’re trying to decide between buying stock in a massive, established investment bank and a plucky young biotech firm, just comparing their P/E ratios won’t be very useful.
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Comparing a company to other similarly sized companies in the same type of business is the best way to judge what a “good” price-to-earnings ratio is. If a stock has a lower P/E ratio than its peers, whether it’s 5, 30 or 50 or more, that’s generally a good sign.
How To Use P/E Ratios When Picking Stocks
Price-to-earnings ratios are one of the most valuable metrics when picking stocks, and investors can follow the practice of “value investing.” This means that you should invest in stocks with low P/E ratios, where you’re getting good value for your investment dollar. Warren Buffett is one of the most notable value investors.
P/E ratios can also paint an incomplete picture, however. Some companies might have high P/E ratios because they’re reinvesting all of their profits internally to become bigger, better companies. They might look expensive based solely on their earnings ratios, but if their lack of profits means they’re growing rapidly, they’re probably still going to be a strong investment in the long run.
A company with a low P/E ratio could be an old company with an outdated business model that’s on the decline. Investors commonly refer to this as a “value trap.” The company may still be profitable, but its prospects for the future are bleak, meaning it wouldn’t be a smart stock to buy.
A company that has taken on lots of debt to fund expansion will likely have a better P/E ratio than its peers, as the money it is borrowing doesn’t reduce earnings. This company might be a much weaker stock overall because of its larger debt load.
Do Your Homework
You should always consider a stock’s P/E ratio before investing, but remember that the number is just one piece of a much bigger puzzle. Any purchase of stock should involve carefully researching the company. Be sure that, in addition to knowing its P/E ratio, you also understand what the number means in the context of the underlying business.
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FAQ
Although the basic idea behind P/E ratios can be simple to understand, using them to make investment decisions can be tricky. Here are the answers to some of the most frequently asked questions regarding P/E ratios.
- Is a high P/E ratio good?
- Generally speaking, a high P/E ratio indicates that a stock is expensive compared to similar stocks with lower P/E ratios. That doesn't necessarily mean it's a bad investment, however. It's important to look at P/E ratios in the context of other factors that make a company worth investing in.
- Is a P/E ratio of 5 good?
- A P/E ratio of 5 is considered low. It could be good if similar companies have higher ratios and investors believe the share price is likely to increase.
- Is a P/E ratio of 30 good?
- P/Es below 15 are considered low and P/Es above 50 are considered high, so on its face, a P/E of 30 is comparatively neutral. You can determine whether it's good by looking at the company's P/E ratios over time, and comparing the current ratio to the ratios of similar companies. It's also a good idea to research the company's financial performance to get a sense of whether it's likely to grow.
- Is it better to have a higher or lower P/E ratio?
- It's usually better to have a lower P/E ratio, which can indicate that a stock is selling at a value price. But there are exceptions. A healthy company with a fortune in cash on its balance sheet might have a high P/E ratio simply because it buys back stock, which returns cash to investors but reduces the number of outstanding shares, skewing the calculation. Investors might be willing to pay a premium for those shares based on the company's strength and growth potential. A company with a low P/E ratio and no other outstanding qualities might be a bad investment if investors perceive a lack of growth potential.
Daria Uhlig contributed to the reporting for this article.
Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.
- Corporate Finance Institute. 2023. "Price Earnings Ratio."
- Charles Schwab. 2021. "Stock Analysis Using the P/E Ratio."
- Corporate Finance Institute. 2023. "Trailing P/E Ratio."
As a seasoned financial analyst with extensive expertise in stock market evaluation and valuation metrics, I can provide valuable insights into the concepts discussed in the article. My experience in financial analysis has equipped me with a deep understanding of the intricacies of stock valuation, particularly through the lens of the price-to-earnings (P/E) ratio.
The P/E ratio is a fundamental metric used by investors to assess the relationship between a company's stock price and its earnings per share (EPS). This ratio serves as a crucial tool for evaluating the profitability of a company in relation to its market valuation. In essence, it indicates how much investors are willing to pay for a company's earnings.
The article appropriately emphasizes the significance of comparing a company's P/E ratio to historical ratios and those of competing firms. This comparative analysis provides a more comprehensive view of a company's valuation. As an expert, I would further highlight the importance of considering industry standards and the size or age of a company when interpreting P/E ratios.
The distinction between forward and trailing P/E ratios is a key aspect of the article. The forward P/E ratio relies on estimates of future earnings, offering insights into the market's expectations for the coming 12 months. On the other hand, the trailing P/E ratio is based on actual earnings over the past 12 months, providing a more historical perspective. Investors should be mindful of the dynamic nature of forward P/E ratios due to changing earnings estimates.
The method of calculating P/E ratios involves dividing the stock's share price by the earnings per share. This straightforward formula is crucial for investors looking to gauge the valuation of a stock at any given moment. The example provided in the article—calculating the trailing P/E ratio with a share price of $20 and an EPS of $0.50—illustrates how the ratio represents the price investors are willing to pay for one dollar of the company's earnings.
Determining what constitutes a good P/E ratio is a critical aspect covered in the article. Generally, a P/E ratio above zero indicates profitability, with ratios below 15 considered low and those above 50 considered high. However, the article appropriately cautions that a lower P/E ratio is not the sole determinant of a good investment. Contextual factors, such as industry standards and the company's growth prospects, must also be considered.
The article advises investors to engage in "value investing," a strategy endorsed by notable investors like Warren Buffett. Value investing involves seeking stocks with low P/E ratios, indicating that investors are getting good value for their investment dollar. However, the article wisely points out that P/E ratios alone can present an incomplete picture. High P/E ratios may be justified for companies reinvesting profits for future growth, while low P/E ratios could be indicative of outdated business models or excessive debt.
In addressing frequently asked questions, the article provides clear and concise responses. It emphasizes that a high P/E ratio does not necessarily make a stock a bad investment, urging investors to consider other factors. The article rightly notes that a P/E ratio of 5 is considered low, but its goodness depends on the context of the industry and other factors. Similarly, a P/E ratio of 30 is described as neutral, with the recommendation to assess it in relation to the company's historical ratios and those of its peers.
In conclusion, the article offers a comprehensive overview of the P/E ratio, providing valuable guidance for investors. As an expert, I would reinforce the importance of thorough research and contextual analysis when utilizing P/E ratios as part of an investment strategy. The information provided aligns with reputable sources, including Corporate Finance Institute and Charles Schwab, further establishing the credibility of the article's content.
