What Is Price-to-Earnings Ratio – P/E Ratio?

The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.

P/E ratios are used by investors and analysts to determine the relative value of a company's shares in an apples-to-apples comparison. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.

Key Takeaways

• The price-earnings ratio (P/E ratio) relates a company's share price to its earnings per share.
• A high P/E ratio could mean that a company's stock is over-valued, or else that investors are expecting high growth rates in the future.
• Companies that have no earnings or that are losing money do not have a P/E ratio since there is nothing to put in the denominator.
• Two kinds of P/E ratios - forward and trailing P/E - are used in practice.

P/E Ratio Formula and Calculation

Analysts and investors review a company's P/E ratio when they determine if the share price accurately represents the projected earnings per share. The formula and calculation used for this process follow.

﻿ P/E Ratio=Earnings per shareMarket value per share​﻿

To determine the P/E value, one simply must divide the current stock price by the earnings per share (EPS). The current stock price (P) can be gleaned by plugging a stock’s ticker symbol into any finance website, and although this concrete value reflects what investors must currently pay for a stock, the EPS is a slightly more nebulous figure.

EPS comes in two main varieties. The first is a metric listed in the fundamentals section of most finance sites; with the notation "P/E (TTM)," where “TTM” is a Wall Street acronym for “trailing 12 months.” This number signals the company's performance over the past 12 months. The second type of EPS is found in a company's earnings release, which often provides EPS guidance. This is the company's best-educated guess of what it expects to earn in the future.

Sometimes, analysts are interested in long term valuation trends and consider the P/E 10 or P/E 30 measures, which average the past 10 or past 30 years of earnings, respectively. These measures are often used when trying to gauge the overall value of a stock index, such as the S&P 500 since these longer term measures can compensate for changes in the business cycle. The P/E ratio of the S&P 500 has fluctuated from a low of around 6x (in 1949) to over 120x (in 2009). The long-term average P/E for the S&P 500 is around 15x, meaning that the stocks that make up the index collectively command a premium 15 times greater than their weighted average earnings.1﻿

Forward Price-To-Earnings

These two types of EPS metrics factor into the most common types of P/E ratios: the forward P/E and the trailing P/E. A third and less common variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

The forward (or leading) P/E uses future earnings guidance rather than trailing figures. Sometimes called "estimated price to earnings," this forward-looking indicator is useful for comparing current earnings to future earnings and helps provide a clearer picture of what earnings will look like – without changes and other accounting adjustments.

However, there are inherent problems with the forward P/E metric – namely, companies could underestimate earnings in order to beat the estimate P/E when the next quarter's earnings are announced. Other companies may overstate the estimate and later adjust it going into their next earnings announcement. Furthermore, external analysts may also provide estimates, which may diverge from the company estimates, creating confusion.

Trailing Price-To-Earnings

The trailing P/E relies on past performance by dividing the current share price by the total EPS earnings over the past 12 months. It's the most popular P/E metric because it's the most objective – assuming the company reported earnings accurately. Some investors prefer to look at the trailing P/E because they don't trust another individual’s earnings estimates. But the trailing P/E also has its share of shortcomings – namely, a company’s past performance doesn’t signal future behavior.

Investors should thus commit money based on future earnings power, not the past. The fact that the EPS number remains constant, while the stock prices fluctuate, is also a problem. If a major company event drives the stock price significantly higher or lower, the trailing P/E will be less reflective of those changes.

The trailing P/E ratio will change as the price of a company’s stock moves, since earnings are only released each quarter while stocks trade day in and day out. As a result, some investors prefer the forward P/E. If the forward P/E ratio is lower than the trailing P/E ratio, it means analysts are expecting earnings to increase; if the forward P/E is higher than the current P/E ratio, analysts expect a decrease in earnings.

Valuation From P/E

The price-to-earnings ratio or P/E is one of the most widely-used stock analysis tools used by investors and analysts for determining stock valuation. In addition to showing whether a company's stock price is overvalued or undervalued, the P/E can reveal how a stock's valuation compares to its industry group or a benchmark like the S&P 500 Index.

In essence, the price-to-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings. This is why the P/E is sometimes referred to as the price multiple because it shows how much investors are willing to pay per dollar of earnings. If a company was currently trading at a P/E multiple of 20x, the interpretation is that an investor is willing to pay $20 for$1 of current earnings.

The P/E ratio helps investors determine the market value of a stock as compared to the company's earnings. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E could mean that a stock's price is high relative to earnings and possibly overvalued. Conversely, a low P/E might indicate that the current stock price is low relative to earnings.

Example of the P/E Ratio

As a historical example, let's calculate the P/E ratio for Walmart Stores Inc. (WMT) as of November 14, 2017, when the company's stock price closed at $91.09.2﻿ The company's profit for the fiscal year ending January 31, 2017, was US$13.64 billion, and its number of shares outstanding was 3.1 billion. Its EPS can be calculated as $13.64 billion / 3.1 billion =$4.40.3﻿

Walmart's P/E ratio is, therefore, $91.09 /$4.40 = 20.70x.

Investor Expectations

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends. When a company has no earnings or is posting losses, in both cases P/E will be expressed as “N/A.” Though it is possible to calculate a negative P/E, this is not the common convention.

The price-to-earnings ratio can also be seen as a means of standardizing the value of one dollar of earnings throughout the stock market. In theory, by taking the median of P/E ratios over a period of several years, one could formulate something of a standardized P/E ratio, which could then be seen as a benchmark and used to indicate whether or not a stock is worth buying.

P/E vs. Earnings Yield

The inverse of the P/E ratio is the earnings yield (which can be thought of like the E/P ratio). The earnings yield is thus defined as EPS divided by the stock price, expressed as a percentage.

2021/04/08 00:52