Investing 101: What Is Price-to-Earnings (P/E) Ratio?

The price-to-earnings ratio is one metric among numerous that investors rely on to determine if they want to invest in a specific company. Analysts also use this metric to compare companies and to compare a company against its historical data and records. 

The calculation for P/E ratios is as follows: 

In other words, to calculate the P/E value, the current stock price is divided by the earnings per share of the company. To do this, investors need to gather key information:

• Price (Market value per share): To determine the market value per share, investors need to determine the current stock price. The current price can be found on the stock exchange by looking up the company's ticker symbol. This can be done on many financial websites, and this price shows what investors are currently paying for the stock. 
• Earnings per share: EPS is the company’s net profit over the number of outstanding shares. EPS helps determine a company’s profitability and is more difficult to calculate. There are two options for determining the EPS:
• Data provided in a company's financial reports often provide EPS guidance, which is the company's best guess on what it expects in the near term. This method uses current information to make future projections.
• The trailing 12 months method looks at the company's performance over the previous 12 months. This method relies on historic performance.

Since the EPS can be calculated using the trailing twelve months or projects using a company’s financial statements, there are two types of P/E ratios depending on how the EPS is determined: 

• The forward price-to-earnings uses future earning projections often obtained using a company’s financial statements.
• The trailing price-to-earnings uses the EPS for over the last twelve months and relies on proven past performance. 

Forward price-to-earnings, sometimes called leading price-to-earnings, uses future earnings guidance. The forward price-to-earnings metric is useful for comparing current earnings to projected future earnings of a company. This method helps to provide more of a future-centered look at what the company's earnings may look like.

The problem with forward price-to-earnings is that companies may underestimate their earnings. They may do this to allow them to beat expectations in their next quarterly earnings report. A company's growth looks more impressive when they exceed their expected growth levels. 

Some companies may also overstate these methods. That forces them to make adjustments in their next earnings call. 

Future P/E may be helpful when it comes from a third party, such as an external analyst. In this case, the analyst uses available information from the company's estimates to determine future P/E. Still, there is always a risk that what is expected does not occur.

Trailing price-to-earnings looks at the company's past performance. Then, it divides the current share price by the total earnings per share from the previous 12 months. 

This metric is the most popular option because it offers an objective view. As long as the company provides accurate information about past earnings, this metric is more reliable. Many analysts and investors prefer this method because it does not require them to use another person's estimates or beliefs to determine the company's performance opportunities.

The big concern with trailing price-to-earnings is that past performance does not indicate the company's future behavior. Investors are not likely to make their decisions to invest solely on the company's past. If some event causes the stock price of a company to rise significantly or drop sharply, these figures are less reliable.

Some investors prefer the future P/E ratio because stocks trade daily, while the information provided about a company's past results is often only released once every quarter. As a result, that information may be dated and inaccurate or ineffective as it applies to the current economy and investments.

As with all factors, investors need to use all metrics available to them before making an investment decision. For some investors, both future and trailing data can be helpful tools.

The P/E ratio is one of the most commonly used metrics by investors when deciding whether to invest in a particular stock. Analysts use these figures to collect data and help guide decision-making. For example, investors using P/E ratios are able to determine the stock's relative valuation. Using this data, investors can then determine if a stock is undervalued, with room to grow, or overpriced, which may mean not it’s not worth investing in at the moment. 

The P/E ratio is also sometimes used as a benchmark to compare one company to the next within the same industry. This benchmark can provide insight into the industry as a whole or, in some cases, provide insight into the broader market. 

The use of P/E ratios is common practice today. It is one of numerous metrics used to make decisions about investments.

Investors can use P/E ratios for many aspects of investing; however, they are often used to better characterize the stock valuation, which is the relative value of a given stock. This provides insight into whether a stock is undervalued or overvalued. Additionally, it can also show how a stock's valuation compares to others within its index. 

This ratio helps provide investors with an idea of how much money they need to invest in a particular company in order to earn $1 of the company’s earnings. Sometimes, the P/E ratio is called a price multiple because it shows how much investors are paying per dollar of earnings. For example, if a company trades at a P/E multiple of 10x, that indicates that the investor is willing to pay $10 for $1 of current earnings.

P/E ratios can also be used to measure a stock's performance by looking backward. For example, P/E 10 and P/E 30 are measurements of the past 10 or 30 years of earnings. Since the various economic factors may create fluctuations in stock price, the P/E 10 and P/E 30 may help to determine the overall value over a longer period of time. This can be especially useful for determining the value of a stock index that may have gone through various periods of unstable fluctuations. These longer looks help to provide valuable insight and compensate for business cycle changes.

Investors must determine what level is "right" for their goals. However, using this standard figure, it becomes easier to compare one company to the next when making an investment decision.

Both the absolute P/E and relative P/E may be used when analyzing a company. Creating a distinction between these two figures allows for a more powerful analysis when characterizing a company’s stock valuation.

The absolute P/E is the P/E calculated for today. The numerator for the absolute P/E is the current stock price, and the denominator is calculated using the previously mentioned methods — using data provided in financial reports or a trailing EPS.

The relative P/E relies on comparing the absolute P/E to the company’s P/E ranges throughout history. Therefore, the relative P/E allows analysts to see how the company’s P/E compares to its historic high and historic low. This number is reported as a percentage, and companies with an absolute P/E lower than the compared value will have a relative P/E below 100%. Meanwhile, companies with an absolute P/E higher than the compared value will have a relative P/E above 100%. 

Relative P/E can be useful for evaluating how a company’s current absolute P/E compares to its historic P/E; however, it’s important to consider historic context when selecting appropriate comparisons. If the stock market began performing poorly during a certain period due to recessions or devastating economic events, it may be unhelpful to use that period’s P/E as a comparison if the current overall economy is performing well.

It depends. P/E ratios are informative only within some frame of reference. The broadest frame is the average P/E ratio of the entire stock market: currently 20-25. More specific guidelines include both historical P/E ratios for that company and the P/E ratios for other companies within the same industry. 

For example, utilities companies generally have low P/E ratios, somewhere around 10, whereas tech companies normally boast much higher P/E ratios. Having studied other businesses in the same sector, investors can begin to ponder whether a given P/E ratio is good or not. Investors also compare the company’s current P/E ratio to its historical ratio and performance.

All other considerations being equal, a lower P/E ratio would be a better bargain because you’re paying less per dollar to buy part of a company’s earnings. But things are not so simple. Investors must consider why a company’s P/E ratio is lower or higher. A company whose business is in decline might well have a low P/E ratio, but would not be a good investment. 

Likewise, one whose high P/E ratio reflects debt the company took on in order to fund a profitable project might be well worth the price. A high P/E ratio generally means that investors are willing to pay more for that company’s stock because they believe that profits will be good in the near future.

Remember that 15 equals 15/1, which indicates that the price is 15 times the earnings. Since the earnings being measured are the company’s yearly earnings, it would take 15 years of profits earned at that same rate to equal the current market price of 100% of its stock.