Using the Price-to-Earnings Ratio as a Quick Way to Value a Stock

Image shows a woman at a computer and gesturing to the price to earnings ratio equation. Text reads: "What to know about price-to-earnings ratio: useful metric for evaluating relative attractiveness of a company's stock price compared to the firm's current earnings; P/E ratio is the price an investor is paying for $1 of a company's earnings or profit. Along with due diligence, examining P/E ratio can help you avoid getting swept away in bubbles, manias, and panics."

The Balance / Maddy Price

A price-to-earnings ratio, or P/E ratio, is the measure of a company's stock price in relation to its earnings. When trying to decide whether to invest in a certain stock, using the P/E can help you explore the stock's future direction.

The P/E ratio can also help tell you whether the price is high or low, compared to other companies in the same sector.

About the P/E Ratio

The P/E ratio was used by the late Benjamin Graham. Not only was he Warren Buffett's mentor, but he is also credited with coming up with "value investing."

Graham preached the virtues of this ratio as one of the best ways to know whether a stock is trading on an investment basis or speculative basis.

Note

An earnings report tells you how a company is performing. The P/E ratio tells you how investors think the company is performing. In other words, it shows how much they are willing to pay for $1 worth of earnings.

How Does the P/E Ratio Work?

Before you can use it, you have to learn what the P/E ratio is. It's easy to calculate as long as you know a given company's stock price and earnings per share (EPS). The equation looks like this:

  • P/E ratio = price per share ÷ earnings per share

Let's say a company is reporting basic or diluted earnings per share of $2, and the stock is selling for $20 per share. In that case, the P/E ratio is 10 ($20 per share ÷ $2 earnings per share = 10 P/E). 

This information is useful because, if you invert the P/E ratio, you can find out a stock's earnings yield. To find the yield, the equation looks like this:

  • Earnings yield = earnings per share ÷ price per share

This information can allow you to compare the return you are actually earning from the underlying company's business to other investments. These may include Treasury bills, bonds, and notes, certificates of deposit and money markets, real estate, and more. 

Be sure to do your research and look out for things such as value traps. But looking at your portfolio through the P/E lens can help you avoid getting swept away in bubbles or panics. It can also help you know whether a stock is getting overvalued and no longer earning enough to warrant its price.

Warning

You should never rely on P/E ratios alone when you choose investments. P/E ratios can help guide you but only along with other research.

P/E Ratios by Sector

Each industry has a distinct P/E range that is normal for that group. For instance, Fidelity research in early 2021 pegged the average health care company's P/E ratio at nearly 70. On the other hand, in the banking sector, companies tended to have a P/E ratio of just under 11.5.

There will always be exceptions, but it's normal for there to be these kinds of contrasts between sectors. That's partly because different businesses have different expectations. In the software sector, for example, companies often have higher growth rates and higher returns on equity. That means they can sell at larger P/E ratios.

In the aftermath of the Great Recession of 2008-2009, technology stocks traded at low P/E ratios, because investors were scared. As the economy improved, investors began returning. By 2021, Fidelity estimated the industry-wide P/E average to be about 42.

How to Compare Companies With P/E Ratios

Not only can you use the P/E ratio to help you know which sectors are overpriced or underpriced, you can also compare the prices of companies in the same sectors. For instance, if two companies, ABC and XYZ, are both selling for $50 per share, one might be far more expensive than the other. This depends on the profits and growth rates of each stock.

Suppose ABC reported earnings of $10 per share, and XYZ reported earnings of $20 per share. ABC has a P/E ratio of 5, while XYZ has a P/E ratio of 2.5.

XYZ is a better purchase at that time, because of the lower share price along with similar earnings. For each share purchased, you're getting $20 of earnings from XYZ rather than $10 in earnings from ABC.

Limitations of the P/E Ratio

Keep in mind that there is not one single ratio or set rule you can apply for investing success. You must factor in what is going on in the world, the markets, and the economy. For instance, if the economy is in trouble, or there is a global health crisis, corporate earnings can be worse than expected, and stock prices can change often. An investment may start to decline and seem fairly valued at a P/E ratio of 14. But then, if you jump into the position too soon without looking at the overall market, the P/E could decline further.

On the other hand, during booming economies, corporate earnings can continue to rise, and the P/E ratio can keep increasing for many years in a row.

A low stock price doesn't always mean you should buy it, and nor does a low P/E ratio. Without broader context, you can't be sure that a low P/E truly signals a good investment.

Some investors may prefer the price-to-earnings growth (PEG) ratio instead, because it factors in the earnings growth rate. Other investors may prefer the dividend-adjusted PEG ratio because it uses the basic P/E ratio. It also adjusts for both the growth rate and the dividend yield of the stock.

The Bottom Line

If you are tempted to buy a stock because it has a good P/E ratio, be sure to do your research and figure out whether it's truly as good as it seems. 

Ask yourself these questions: Is management honest? Is the business losing key clients? Is the stock price or performance a result of forces across the entire sector, industry, or economy? Or is it caused by firm-specific bad news? Is the company going into a state of decline?

The basic P/E ratio is an indicator that's great when used in context, but it's not all that useful by itself—at least not until you become very familiar with your investments and opportunities.

As you learn more about the ratios, along with the sectors you want to invest in, you'll be able to view a company's P/E from a certain time. Then, you can decide whether it is a good indicator or not.