Understanding the price-to-earnings (P/E) ratio
Read on to discover what the P/E ratio is and why it matters so much.
What is the P/E ratio?
A price-to-earnings (P/E) ratio is a metric regularly used by investors who want to determine the relative value of a company’s shares. They’ll usually do this by looking to other companies in the same industry, limiting the number of variables in play.
Also referred to as a “price multiple” or “earnings multiple,” a P/E ratio compares a company’s share price to its earnings per share (EPS), weighing said company against its past performance. A P/E ratio can take the form of either of the following:
A Trailing P/E – calculated using recent past earnings. This is more common, especially for external use by investors, because these figures are more readily available.
A Forward P/E – calculated using projected future earnings.
Companies with no earnings or losing money cannot calculate P/E ratios. For all other companies, though, they can function as a helpful barometer. For example, a “high” P/E ratio indicates a company’s stock is overvalued.
Why is the ratio of price to earnings so important?
P/E ratio is a widely used metric in the stock markets, and it has been for quite a while. It’s utilized by investors new and old, big and small, and it’s one of the most essential tools in your arsenal because:
It indicates if prices are higher than the business’s current earnings.
It can highlight insufficient fund management.
It can tell you if stock prices are undermined.
Observing what the market is willing to pay for a stock today based on past or future earnings is a must-have. It’s a measuring stick that identifies overvalued or undervalued stocks and allows you to adjust your portfolio accordingly. The sooner you can get your head around P/E calculations, the quicker you can benefit from these insights. Don’t be afraid to enlist the help of a financial advisor if necessary!
How to calculate a P/E ratio
Now that you’ve developed your comprehension of P/E and gathered how valuable it can be to your overall investment strategy, it’s time to dive into how a P/E ratio is calculated. It’s simpler than you think, and it starts with determining a company’s earnings per share (EPS):
Net income ¸ Total number of diluted shares outstanding = EPS
At this stage, you’ll divide either the latest share price or the predicted future share price (this will dictate whether the calculation is “Trailing” or “Forward,” with “Forward” generally reserved for internal analyses and not utilized by investors) by the company’s EPS:
Market share price (past or future) ÷ EPS = P/E ratio
You could also calculate a P/E ratio by dividing a company’s equity value by its net income:
Equity value ÷ Net income = P/E ratio
Both formulas will yield similar results, with any differences arising from the fact that EPS is calculated using the weighted average number of shares. At the same time, net income measures the profitability of a company’s operating performance in a specific timeframe.
What is a good P/E ratio?
A P/E ratio is displayed in a “#X” format that tells you how many times higher the stock price is compared to the EPS. For example, #22 would indicate that the stock price was 22 times the EPS, while #12 would mean the stock price was 12 times the EPS.
Understanding what makes a good P/E ratio is imperative when making a successful investment. Generally, the average P/E ratio stands somewhere between 20 and 25. Anything below this is considered a good/“low” P/E ratio. Investors believe that the stock’s earnings will decrease and may be undervalued, presenting an opportunity.
On the other hand, anything above 25 is considered worse than average or “high.” Investors believe that the stock’s earnings will increase, and the stock may be overvalued, presenting a problem.
It’s important to note that the P/E ratio can vary depending on the industry, with different sectors possessing different average P/E ratios. This is why, as briefly mentioned at the start of this article, investors usually choose to compare P/Es between companies in the same industry rather than pitting general, cross-industry P/Es against each other.
If you have questions about P/E ratio calculations or the meaning of a “high” or “low” ratio in the context of a particular company, a financial advisor can help.
How can I use P/E ratios in my investment strategy?
P/E ratios (primarily Trailing P/E ratios) are commonly relied upon among investors. By calculating this ratio for a company, an investor can get a comprehensive look at its financial health and potential for growth. Though a P/E ratio shouldn’t be the only factor you consider when deciding whether or not to invest, it’s an excellent way of guiding your hand, and it will reliably inform you regarding matters of profitability.
For instance, you plan to invest in a specific industry area, like organic farming. P/E calculations will be beneficial as you analyze comparative organic farming companies to find the best fit and value.
At this stage, you should have a stronger sense of what P/E means and its role for investors across the US and the rest of the globe. Whether you’re confident calculating P/E yourself or want to leave it to your financial advisor/asset manager, being informed and aware of industry metrics such as P/E can’t be overstated.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.