What Is a Price-to-Earnings (P/E) Ratio?

How to Calculate a P/E Ratio

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A price-to-earnings ratio, otherwise known as a P/E ratio, is a quick calculation used to evaluate how expensive or cheap a stock may be at any given time.

What Is a Price-to-Earnings (P/E) Ratio?

Just as an appraiser can come out and give you an estimate of the value of your home, the price-to-earnings (P/E) ratio is a tool you can use to estimate the fair value of the stock market.

The P/E ratio is also a metric used to help compare stocks in the same industry to one another. The P/E ratio is not as useful when comparing stocks across different industries or those that produce different products and services.

Some industries are known to have much higher P/E ratios than others, so only compare like with like.

For example, the advertising industry in January 2021 had a P/E ratio of 20.95 while the aerospace industry P/E ratio ran at 291.56.

How Do You Calculate a P/E Ratio?

In simple terms, a P/E ratio is the price (P) divided by earnings (E).

Price to Earnings (P/E) Ratio

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 because you are now 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 the P/E ratio based on last year’s earnings. This is also called the TTM method for Trailing Twelve Months.
  2. Use a future forecast of earnings either provided by the company or by stock analysts. This method is known as the Forward P/E Ratio.
  3. Take a broader view by using a 10-year average of past earnings adjusted for inflation. This is something called P/E 10, Shipper P/E Ratio, or CAP/E which stands for cyclical adjusted price-to-earnings.

How Price-to-Earnings Ratios Work

Price-to-earnings 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 '90s to a low of 7 at the bottom of a few bear markets.

The P/E ratio for an individual stock is telling you if the market is overvaluing that particular stock based on how many people are willing to buy it and its value over time. Generally, the lower the number the better because it suggests the company may be undervalued, and worth buying.

Limitations to P/E Ratios

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 the data too narrowly and forget that the "E," which is earnings data, is either past data (and the future may be different) or the 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. 

A volatile market can affect the short-term P/E ratio and make it less reliable. The P/E ratio also fails to include any consideration of future earnings growth.

Difference Between P/E Ratio and PEG Ratio

The PEG ratio, meanwhile, incorporates earnings growth by measuring the ratio between the price/earnings ratio and earnings growth.

PEG Ratio equation
P/E Ratio vs. PEG Ratio
P/E Ratio PEG Ratio
Looks at share price vs. earnings per share Looks at share price vs. earnings per share vs. growth in earnings per share
Lower P/E ratio is preferable Lower PEG ratio is preferable

Key Takeaways

  • A price-to-earnings (P/E) ratio is a tool to evaluate the value of a stock price.
  • In its simplest form, it is price divided by earnings.
  • Different industries have different P/E ratios, so only compare like to like.
  • It's easy for novice investors to misinterpret the P/E ratio.
  • For that reason, many investors prefer to use the PEG ratio, which includes earnings growth.