What is the P/E Ratio and How Does it Work?

The price-to-earnings ratio—often referred to as the P/E ratio—is a popular metric used in corporate finance to assess the relative value of a company. The P/E ratio may also be referred to as a “price multiple” or an “earnings multiple.”

The P/E ratio is widely used as a tool for estimating a company’s value. And by calculating the P/E ratio of a given company, one can compare that ratio to other companies in the same sector, as well as to companies in other sectors.

To determine the P/E ratio, one simply takes the price per share of the stock and divides it by the earnings per share (EPS) of the stock. The calculation is therefore: P/E Ratio = Price per share/Earnings per share.

Mathematically, the P/E calculation is relatively straightforward. To determine the P/E ratio, one simply takes the price per share of the stock and divides it by the earnings per share (EPS) of the stock. The calculation is therefore: P/E Ratio = Price per share/Earnings per share.

To ascertain the current price per share, one simply pulls up the most recent quote for the stock in question. However, the earnings per share may be approached in two different ways—commonly referred to as “trailing P/E” and “forward P/E.”

Trailing P/E utilizes the earnings per share for the trailing 12 months (aka TTM), while forward P/E is based on earnings guidance from the company, and is more of a “best guess.”

Looking at a simple example, imagine that hypothetical stock XYZ is currently trading at $24.00/share, with a trailing earnings per share of $2.00 for its most recent fiscal year. The P/E ratio for XYZ is therefore equal to 12 ($24/$2 = 12).

The P/E ratio is widely used as a tool for estimating a company’s value. And by calculating the P/E ratio of a given company, one can compare that ratio to other companies in the same sector, as well as to companies in other sectors.

The insights provided by this type of analysis are important, because they reveal how companies are valued versus their peers, and across different industries.

For example, some industries trade with higher price multiples, as compared to others. The P/E ratio may also shed light on valuation discrepancies for companies in the same sector. And in such cases, some investors and traders may view these discrepancies as trading/investing opportunities.

For example, the P/E ratio for the S&P 500 is calculated by taking the average stock price of large-cap stocks in the S&P 500 Index and dividing that collective price by the mean earnings of those companies. The result of that calculation typically equates to what is commonly referred to as the P/E of the "market.”

This figure is important because it can be tracked over time. Since the early 1900s the average P/E for the S&P 500 market has hovered around 17. In practical terms, that means the stocks that make up the index collectively command a premium 17 times greater than their weighted average earnings.

When the market’s P/E rises above 17—especially to an extreme degree—some market participants start to worry about "overvaluations” in the market. The same can be said when the market's P/E drops below 17, although in that case the concern is that stocks might be getting undervalued.

Looking at an example for a single stock, imagine that hypothetical stock XYZ is currently trading at $24.00/share, with a trailing earnings per share of $2.00 for its most recent fiscal year. The P/E ratio for XYZ is therefore equal to 12 ($24/$2 = 12). That implies XYZ trades at roughly 12 times its trailing earnings.

Once the P/E ratio is calculated, one can compare the P/E ratio of XYZ to its peers in the same industry/sector, or to the market as a whole.

For example, comparing the P/E ratio of XYZ to the broader S&P 500, one can see that XYZ trades at a lower multiple than this large, diversified index (12 vs 17). That may indicate the market thinks XYZ will generate lower earnings growth as compared to the average company in the S&P 500.

It’s also possible that XYZ’s industry/sector trades with a lower average P/E as compared to other market sectors, and that XYZ’s P/E of 12 times earnings is appropriate, and in-line with its peers.

Alternatively, stocks can also trade with elevated P/E ratios, which may be attributable to an expectation that the stock will grow its earnings at a faster rate than the average stock in the market. Stocks with elevated P/E ratios are often labeled as “growth stocks.”

If those earnings expectations don’t come to fruition, the market’s perception of that elevated earnings multiple might change, and the stock may instead be viewed as overvalued.

The P/E ratio is used to provide insight into the value of a given company, or the market as a whole.

As a result, a P/E ratio isn’t usually considered “good” or “bad.” Instead, a P/E ratio might indicate whether a given company is valued in line with its peers, below its peers, or above its peers. Depending on the circumstances, that assigned value may be appropriate, or it may suggest there’s an opportunity available to investors/traders.

For example, a given stock may trade at a lower earnings multiple because it is expected to grow its earnings at a slower rate than the average company in the S&P 500. But if an investor or trader expects the company to produce greater earnings growth than the market expects, he/she may view that stock as a good investment.

As such, the P/E ratio provides market participants with an important data point that can be used to further analyze the market valuation of a given company. If the P/E ratio is at an extreme—as compared to its peers or the market as a whole—it’s up to the investor/trader to ascertain whether the P/E in question is appropriate.

Depending on the investor/trader’s own unique interpretation of the data, an unusual P/E may indicate that a stock is undervalued or overvalued. Moreover, an investor/trader may decide to act on that perspective, by expressing his/her opinion in the market.

The price-to-earnings ratio—often referred to as the P/E ratio—is a popular metric used in corporate finance to assess the relative value of a company. The P/E ratio may also be referred to as a “price multiple” or an “earnings multiple.”

Earnings yield, on the other hand, is the inverse of the P/E ratio. Earnings yield is calculated by taking the trailing earnings per share (EPS) and dividing it by the current price per share of the stock.

Looking at a simple example, imagine that hypothetical stock ABC is currently trading at $60.00/share, with a trailing earnings per share of $3.00 for its most recent fiscal year. The earnings yield would therefore be equal to roughly 5% ($3.00/$60.00 = .05, or 5%).

Investors and traders sometimes interpret the earnings yield as the amount of earnings one receives for each dollar invested in the company’s shares. Therefore, in this example, an earnings yield of 5% suggests that each dollar invested into ABC’s shares generates $0.05 of EPS.

The earnings yield can also be compared to prevailing interest rates—often via the yield on the 10-year Treasury bond. For example, if an earnings yield is lower than the 10-year Treasury yield, a stock may be considered overvalued. Or, iff the earnings yield is higher than the 10-year Treasury, a stock may be considered undervalued relative to bonds.

Earnings yield isn’t referred to that frequently, especially in comparison to the P/E ratio— the latter is commonly utilized by investors, traders and market analysts.

The price-to-earnings ratio—often referred to as the P/E ratio—is a popular metric used in corporate finance to assess the relative value of a company. The P/E ratio may also be referred to as a “price multiple” or an “earnings multiple.”

In addition to the regular P/E ratio, some investors and traders also analyze the price/earnings-to-growth ratio, or price/PEG ratio. This metric is often referred to as simply the “PEG ratio.”

The PEG ratio can be a valuable complement to the P/E ratio because it factors in a company’s expected earnings growth. The PEG ratio is often used in concert with the P/E ratio to assess the relative value of a company.

One important limitation of the PEG ratio is that it relies heavily on the earnings growth assumption used in the calculation. For example, one could use a 1-year earnings growth rate, a 3-year earnings growth rate or a 5-year earnings growth rate.

Moreover, the exact estimate used for the earnings growth rate will also vary. For example, one analyst may estimate the earnings growth rate over a 1-year period, using one set of assumptions. While another analyst may estimate the growth rate over a 1-year period, using a different set of assumptions.

For these reasons, one PEG ratio may not be easily comparable to another.

Regardless, the PEG ratio can still provide important insights. Mathematically, the PEG ratio is calculated by taking the P/E ratio and dividing it by the expected growth percentage. As such, the calculation is: PEG ratio = (Market Price/EPS)/EPS growth rate.

Looking at an example, imagine hypothetical stock DEF is trading for $50.00/share, and has a trailing EPS of $3.00. Now imagine that the trailing EPS for the year prior is $2.25.

To ascertain the PEG ratio, one simply calculates the P/E ratio and then divides that figure by the EPS growth rate. In this case, the P/E ratio is equal to about 16.5 ($50/$3 = 16.5).

Next, it’s necessary to calculate the earnings growth rate, which is equal to: [($3.00/$2.25) - 1] = 0.33, or 33%. The last step is to divide the P/E ratio by the earnings growth rate, which is 0.50 (16.5/33 = 0.50).

In this example, the PEG ratio for the hypothetical company DEF is 0.50.

In general, PEG ratios under 1.0 are preferred, as that may imply that the company in question is undervalued relative to its future earnings potential. A PEG ratio above 1 suggests the opposite—that a company may be overvalued as compared to its future earnings potential.

Investors and traders should keep in mind that PEG ratios aren’t necessarily comparable because of the varying assumptions that may be used in this ratio’s calculation.