What Is the Price-to-Earnings Ratio and How to Calculate It?

The price/earnings ratio is one of the more popular tools for evaluating stocks. This indicator compares the stock price to the company earnings and, therefore, can help an investor decide whether the current stock price is justified.

So, what does the P/E ratio mean, how to calculate it, and what is a good price-to-earnings ratio? By the end of this article, you will know all of this and more!

What Is the P/E Ratio?

The price-to-earnings ratio, or P/E, is an effective focal point for stock valuation, although it is far from the only one. Comparing stock prices with earnings is a great way to evaluate a company. This calculation is at the heart of the P/E ratio, meaning you’ll get to see how much you’re going to pay for every dollar of earnings. Using P/E is also a good way to get a complete picture of a company’s stock compared to its peers in the industry or even the entire market, making it even more popular among analysts and investors.

It is important to note that low price-to-earnings does not mean that the company is on the decline. The low price-to-earnings ratio may indicate that investors are losing confidence and selling shares, while profits may remain stable. The low P/E can also signify that the company’s profits are actually increasing, and the investors simply haven’t caught on yet. A high price-to-earnings ratio, on the other hand, can emerge when investor anxiety causes the stock price to rise while earnings remain low. However, a high P/E usually signifies that the company is poised for growth.

There are three ways to measure the price-to-earnings ratio — each of these approaches takes into account different information about a stock or index.

Trailing Twelve Month (TTM) Earnings

The first way of determining P/E is by using the company’s earnings data for the last year. This approach is known as the trailing P/E ratio. This method is the most popular, as it uses actual data and reported information.

Forward Earnings

This method is the complete opposite of the previous one — it is based on an estimate of the company’s future earnings. Although the forward P/E metric is not based on reported data, it is supremely useful for revealing what results the market expects from the company in the next year.

The Shiller P/E Ratio

The Shiller ratio is based on the company’s average earnings over some time. To calculate it, you’ll need to divide the price by the average earnings over the last ten years (with an inflation margin).

P/E Ratio Calculation

In simple terms, the P/E ratio is the stock price divided by the company’s earnings per share. The basic price-to-earnings ratio formula is:

Current Price / Latest Earnings per Share = P/E Ratio

So, how to calculate the P/E ratio?

1. Determine Earnings Per Share (EPS)

Earnings per share is one of the most important financial parameters, and it is essentially an indicator of the company’s performance and resilience. EPS stands for the “E” or the profit part of the P/E valuation criteria.

2. Determine Share Price (P)

You can find out the share price (P) component of the formula by searching the stock ticker on a reliable financial resource. The P/E calculation typically uses the current share price, but an average over a period is also acceptable.

The important point to note here is that the P/E ratio is calculated not only for stocks but also for entire stock indices. Still, remember that prices are constantly fluctuating, and the price-to-earnings metric is always subject to dynamics and changes.

Price-to-Earnings Ratio Interpretation

High vs. Low P/E Ratios

Companies with a high P/E ratio usually have growth stocks, which in turn can indicate a positive dynamic. However, if the stock price is high relative to earnings, the stock may be overvalued. As usual, inflated expectations encourage investors to invest more money.

You should also note that growth stocks tend to be highly volatile, and this pressure can force companies to use risky strategies to justify the high valuation. For this reason, investing in stocks with high P/E ratios is generally considered a risky move.

A low P/E, on the other hand, can signal that you’re dealing with value stocks. In practice, this indicates that the stocks are undervalued, as they are trading below their basic indicators. Typically, a negative P/E encourages investors to buy the stock before the market corrects, as when it does, they will profit from the increase in the stock price.

Comparing P/E Ratios

One of the key uses of P\E ratio is comparing one company’s performance to another. However, checking a stock’s P/E ratio will tell you little. To get a more complete picture, you need to compare the current P/E ratio of the company to its historical ratio or the P/E ratio of a competitor in the same industry.

Thus, the price-to-earnings ratio can allow you to value a company on its own, as well as in comparison to similar companies or the market.

Limitations of the P/E Ratio

The price-to-earnings ratio has some limitations due to unrelated factors that can affect it. These include volatility and instability of market prices, the difficulty of determining the precise composition of a company’s earnings, and the lack of an earnings growth indicator in the P/E ratio formula. Another key drawback of the price/earnings ratio is that it is not very indicative of a company’s EPS potential. Investors and analysts believe that it is not always clear when a high P/E is a logical result of expected growth and when it means that a stock you’re trying to analyze is just overvalued.

Another limitation of P/E is that it offers very little data on its own, meaning you must be prepared to do in-depth research, study the company’s financial data, and use other financial valuation methods. Due to the reasons outlined above, a P/E analysis may also show inconsistent results. Furthermore, you may have difficulty calculating the P/E for companies that do not currently have profits or have negative earnings per share. Last but not least, the price-to-earnings formula won’t do you much good when comparing companies from different industries.

Among other critical things that you should consider when using the P/E ratio is that your information should only come from reliable and trustworthy sources, as this data is easily manipulated.

Final Thoughts

Remember that despite all of its uses, a price-to-earnings rate is just one of the metrics you should consider. The P/E is a great starting point when analyzing companies, but it is by no means the only one.

The only real exception to this rule is when you use the P/E formula as a comparative tool when dealing with companies in the same industry. And even then, you should not rely on the price-to-earnings ratio calculation alone — it is just an auxiliary tool that should be used in conjunction with other data.