The price-to-earnings ratio (or P/E ratio) is a way to evaluate whether a company’s stock is cheap, expensive, or fairly priced given its current share price.
Just like a T-shirt could be cheap if you buy it at a discount store or expensive if you buy it at a high-end boutique, stocks can be cheap or expensive too. P/E ratios are the main tool investors use for assessing this.
The P/E ratio compares a company’s stock price to its profits. It’s calculated with the following formula:
stock price / earnings per share
Said another way, it tells you how much you’re paying per dollar the company earns in profits (earnings per share is just a company’s total profits divided by its number of shares).
For example, if a company has a P/E ratio of 20, investors are willing to pay $20 for every dollar it earns in profit.
P/E ratios are always used to judge how cheap or expensive a stock is. But just knowing that a stock has a P/E ratio of 20 doesn’t tell you this on its own.
Instead, investors typically compare different P/E ratios to determine whether a given stock (or group of stocks) is a good value at its current price. For example, investors may compare P/E ratios:
All else equal, a lower P/E ratio is better.
“Buy cheap and sell dear.“
There are two ways of calculating a P/E ratio. They are:
|Trailing P/E||Forward P/E|
|How it’s calculated||Price
EPS for past 12 months
EPS that analysts predict for next 12 months
|Pro||No guessing involved because it’s based on certain numbers||Based on expectations, which are what drive stock prices|
|Con||Past EPS is old news; investors and traders care about the future||Analysts are often wrong|
The P/E ratio is one of the most widely used metrics investors use for evaluating stocks. But it does have some weaknesses, including:
A P/E ratio is a good back-of-the-napkin estimate, but it doesn’t give a total picture of whether a stock is a good buy.
A company could have a high P/E ratio because its profits are growing incredibly quickly. Judged on the ratio alone, it might look like a bad investment, but the stock could actually have great prospects.
On the other hand, a company could have a low P/E ratio because it’s struggling, and its stock price has fallen. If the company ends up recovering, then investors will do well—but sometimes struggling companies never recover (and investors end up losing everything).
P/E ratios can help investors decide whether a stock is cheap (and a good buy) at its current price or expensive (and a bad buy). The ratio is calculated by dividing a company’s stock price by its profits per share. Although lower ratios are generally better, P/E ratios should be just one factor to consider when evaluating a stock for investment.