What is a Price to Earnings or P/E Ratio?

Price to earnings ratios can be useful if you know how to use them.

Stock market graph
A P/E ratio can be a helpful tool when you know how to use it.. Credit: Saul Gravy

A price to earnings ratio, otherwise known as a P/E ratio, is a quick calculation used to evaluate how expensive, or cheap, the stock market may be at any given time. Just as an appraiser can come out and give you an estimate of the value of your home, the P/E ratio is a tool you can use to estimate the fair value of the stock market.

It is also a metric used to help compare similar stocks to one another.

By similar I mean stocks of companies in the same industry or companies who produce the same type of product or service.The P/E ratio is not as useful when comparing stocks across different industries, as some industries are known to have much higher P/E ratios than other industries.

How is a P/E ratio calculated?

In simple terms, a P/E ratio is the price (P) divided by earnings (E). A stock with a price of $10 a share, and earnings last year of $1 a share, would have a P/E ratio of 10. If the stock price goes up to $12 a share and the earnings stay the same, the stock's P/E ratio would then be 12 and the stock would be relatively more expensive as now you are paying a higher price per dollar of earnings.

There are many ways to calculate P/E ratios. The most common three formulas used are:

  1. look at P/E ratio based on last year’s earnings
  2. use a future forecast of earnings either provided by the company or by stock analysts
  1. take a broader view by using a ten year average of past earnings (something called P/E 10 or CAPE which stands for cyclical adjusted price-to-earnings

In addition, P/E ratios for an individual stock must be interpreted much differently than P/E ratios for the market as a whole. The P/E ratio for the S&P 500 has ranged from a high of 40 during the tech bubble in the 90's to a low of 7 at the bottom of a few bear markets.

 

P/E ratio mistakes

Novice investors can often make the mistake of using a P/E ratio to buy a stock that appears undervalued, or sell one that appears overvalued. They interpret that data too narrowly and forget that the "E", which is earnings data, is either past data (and the future may be different) or earnings data is an estimate of the future (and the future may be different). For this reason, use P/E ratios with caution, and don't use them as single decision making tool. 

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