Price-to-Earnings Ratio: Definition, Calculation, and Examples
The price-to-earnings ratio is a measuring stick for valuing companies. Its current share price is compared to its earnings per share, thereby giving analysts and investors a glimpse of whether the company is overvalued or undervalued.
The P/E ratio can be based on past performance (trailing) or estimated future performance (forward).
P/E ratios are simply a way of comparing how much you are paying for each dollar of a company's earnings. In general, a higher P/E ratio means that investors are willing to pay more for each dollar of earnings. This is typically seen with growth stocks and P/E is generally less relied on by growth investors. If you are a value investor then P/E is much more relevant.
How do you calculate the P/E ratio?
The P/E ratio is calculated by dividing a company's share price by its earnings per share (EPS). For example, if a company has a share price of $30 and an EPS of $5, its price-to-earnings ratio would be 6 ($30/$5).
What does the P/E ratio tell you?
The P/E ratio can tell you whether a stock is expensive or cheap relative to other stocks. It can also be used to compare companies within the same industry.
A high P/E ratio could mean that a stock is overvalued. A low P/E ratio might indicate that it's undervalued. But, keep in mind that a high or low P/E ratio doesn't necessarily mean that a stock is a good buy or sell.
The reason why the price-to-earnings ratio is important is that it's one of the most common ways to value stocks.
If you focus on high-growth stocks, they are all going to have high P/E ratios that tell you the stock is overvalued and it can get confusing, so it might be best to ignore this calculation altogether unless you are a value investor.
Is Price-to-Earnings Ratio Reliable?
The P/E ratio is a popular stock valuation metric, but it's not perfect. It tends to be a better measurement for value investors than growth investors. High-growth stocks have a high P/E because investors pay a premium for the fast and long-term growth potential. A common mistake that growth stock traders make is not investing in a stock because they believe the company's stock price is overvalued.
Growth stocks can have high P/E ratios and still be great investments. The key is to focus on the company's fundamentals, such as sales growth, earnings growth, margins, cash flow, and return on equity. You know, the CANSLIM stocks!
Forward P/E vs Trailing P/E
The trailing P/E is the current P/E ratio using the past 12 months of earnings. The forward P/E uses estimated earnings for the next 12 months.
The difference between the two is that the trailing P/E uses actual earnings while the forward P/E uses estimated earnings. The trailing P/E can sometimes give you a false sense of security because the past performance over the last 12 months might not be representative of the company's future growth.
What's considered a “good” P/E ratio?
There is no magic number when it comes to P/E. A “good” or “bad” P/E ratio depends on a number of factors, including the company's growth prospects, industry trends, overall market conditions, etc.
Below are some average P/E for two of the top-performing growth stocks from the 5 year period of October 1, 2017 – October 1, 2022:
AMZN average P/E was 107.78.
TSLA average P/E was 530.71.
It is always important to look at the P/E of similar companies. Stocks in the same sector and industry groups with competitive products can be considered similar companies.
Limitations of using the P/E ratio
The P/E (price-to-earnings) ratio has limitations. A high P/E might suggest a stock is expensive compared to its earnings. However, this could be because the company is growing fast and expected to keep growing.
A low P/E might seem like the stock is cheap relative to its earnings. But this could be due to the company being in a declining industry or having a history of poor earnings.
The P/E ratio doesn't give the full picture and is just one measure. Investors who focus too much on P/E might miss great opportunities. It's important to consider other factors and a broader analysis.
Price Earnings Ratio Conclusion
P/E ratios are a popular stock valuation metric, but it's not perfect. Growth stocks can have high P/E ratios and still be great investments. The key is to use it as one metric of many when analyzing a stock. A stock might be considered undervalued or overvalued for a variety of reasons, so it's important to look at other factors and not just what the ratio shows you.
Overall, if you use technical analysis, you can identify areas where the price may increase or the price may decrease on the chart itself.