Aja McClanahan is a personal finance writer who has a story of getting out of over $120,000 in debt. She's been featured in Yahoo! Finance, MarketWatch, U.S. News and World Report, Kiplinger and has written for publications like Business Insider, Credit Karma, Inc., and many others. Aja writes about investing and personal finance for Wealthsimple. In her spare time, she manages her own investment portfolios for herself, husband, and two kids. Aja double majored in Spanish and Economics and holds a Bachelor of Arts degree from University of Illinois at Urbana-Champaign.
Whether you’ve started on a serious investing journey or are well into it, you’ve probably heard some investing buzzwords that include the phrase “P/E Ratio.” Before you chalk up investing phrases like this one for the likes of Wall Street tycoons, you should know that the concept of the P/E ratio isn’t that hard to understand. In fact, knowing just a little bit about this ratio could help you learn more about a particular stock.
What is the P/E ratio?
The P/E ratio compares a company’s share price in to its profits (per share.) You can also think of the P/E ratio as the price you’ll pay for $1 of a company’s earnings (or profits.) So if a company’s P/E ratio is 10, you are paying $10 for $1 of profit per share.
The P/E ration is how investors determine the value of a stock. Many investors will avoid stocks that are overvalued (i.e. expensive) and seek out stocks that are undervalued. Overvalued stocks are at risk for losing their value while undervalued stocks could grow in value over time—as a result many investors consider them a good investment.
Although there are some investors who will invest in seemingly over-valued stocks in more sophisticated trading scenarios, we’ll focus on investors who take a value-based approach to choosing stocks for a longer-term investing strategy. The value-based investing preference is one reason analyzing key metrics like the P/E ratio can help investors choose stocks that fit within their investing goals.
How to calculate a company’s P/E ratio
This ratio is calculated by dividing a company’s stock price by the company’s earnings-per-share (EPS.) For example, if a company’s share price is currently $30 and the EPS is currently $10, the P/E ratio would be 3.
Fortunately, you don’t have to calculate this ratio yourself, as there are many resources that calculate this number for you. Many finance sites have pages with data points of stocks that include the P/E ratio. If you have an online self-directed trading account or use an investing app, you can view the same data points within the app or online interface.
When you are looking at stock in a financial directory like the ones mentioned above, you should also see a company’s P/E ratio plus the numbers that comprise this number, including the company’s stock price and EPS. You should know that the P/E ratio you will typically see is from a trailing 12-month (TTM) average, meaning the last 12 months of EPS are used in the calculation. Additionally, it’s good to know that a company’s P/E ratio will change daily as the company’s stock price fluctuates while the EPS is usually updated quarterly when companies release their earnings reports.
The average P/E ratio for stocks hang around the 20-25 mark. This means that investors are willing to pay $20-$25 per $1 of company earnings. However, there are certain industries where that average tends to be much lower or much higher.
For example, companies in high-growth categories like technology, bio-tech, emerging markets or start-ups or other growth-oriented stocks could have higher P/E ratio than the stock market average. A stock like Amazon (AMZN) has a P/E ratio around 74.
The mean P/E ratio of the S&P 500 currently sits at 15. This means this company’s earnings are considerably more expensive than the index it’s a part of. An investor who likes to invest in the S&P because of its relatively low P/E ratio, may avoid a stock like Amazon as the P/E ratio could indicate that it’s over-valued.
In other words, the market is charging a premium for the stock price even though the earnings per share may not justify the higher share price. A preference for undervalued stocks might deter an investor from investing in a company like Amazon until the P/E ratio adjusts to his or her liking.
On the other hand, more stable, blue-chip stocks could have lower P/E ratios, which can signal to investors a potential better deal. An undervalued stock according to the P/E ratio could signal to a “value investor” that this stock is a good investment and will increase in price over time.
Use and limitation of the P/E ratios
We already discussed how investors use the P/E ratio to assign a value to a stock compared to its earnings per share. This ratio can be used by investors to value stocks in comparison to one another, too. Investors may also use this ratio to analyze certain industries or stock indices. For example, it’s not uncommon for investors to compare the P/E ratio of the S&P 500 to the P/E ratio of an individual stock.
Even though the P/E ratio is a widely-used metric to help investors evaluate stocks, it does have its limitations. With the Amazon example, we can see that its P/E of 74 means its profits are pretty expensive. However, if you look at Amazon’s IPO price of $18 back in 1997 versus its current trading price (around $1,800 in September of 2019) you can see that just a small investment in Amazon shares would have proved to be a great investment.
Plus, the P/E ratio for the company has fluctuated wildly over the years, being as high as 3,732.43 and as low as 25.94. If you are buying Amazon stock in 2019, a P/E ratio in the 70s would still make it a reasonably valuable stock when compared to historical figures.
Also, P/E ratios are based on company earnings which can be subject to out-of-the-ordinary gains or losses. This can cause the P/E ratio to be somewhat skewed in some cases. Also, this number can be calculated with different accounting methods which can distort the bottom line a company reports and affect the P/E ratio in the same way.
Another limitation of the P/E ratio is that it’s based on past earnings. Once these figures are reported by a company, the earnings per share number is based on past performance. Even though the stock price is being updated daily, the earnings figures can be up to 3 months old since they are typically reported quarterly. This actually presents two issues: 1. The P/E ratio is not updated in real-time 2. The P/E ratio is based on historical earnings that don’t really indicate future success for any given company or its stock.
It’s important to incorporate a company’s balance sheet into your analysis. In other words, P/E ratios don’t account for differences in companies that carry a lot of debt on their balance sheet versus those that don’t. Debt can definitely impact a company’s financial performance and valuation but the P/E ratio doesn’t take debt (or lots of cash) into account.
Pros & Cons of the P/E ratio
There are many pros and cons of the P/E ratio, here are some of them.
Easy figure to calculate; readily available datapoint for most stocks
Helps investors quickly estimate the value of a stock
Helps investors compare a stock among other stocks, industries, indices, etc.
Doesn’t provide a thorough or complete analysis of a company’s stock
The ratio can be manipulated with varied accounting practices
Not updated in real-time
It’s based on earnings figures from the past
Doesn’t take into account a company’s debt (or cash)
What does it mean when a company has a negative P/E ratio?
A negative P/E ratio means that the earnings per share is a negative number. In other words, the company is not yet profitable and is operating at a loss. If you look up companies like Uber (UBER), Snapchat (SNAP) or even Tesla (TSLA) you will see that they report losses and have no P/E ratio to speak of. Though it’s mathematically possible for a company to have a negative P/E ratio, it’s not a widely accepted practice to report it as such. If you are looking at the data points on a company’s stock, a negative P/E will be reported as N/A, “-” or left blank.
Other P/E Ratios
There are other “flavors” of the P/E ratio that can add to your your stock analysis if you feel like the ratio has too many limitations.
The price/earnings to growth ratio or PEG ratio is a stock's price-to-earnings (P/E) ratio divided by the growth rate of its earnings. It helps an investors arrive at a stock’s value but also factors in a company’s expected earnings growth over a given time period.
The forward PEG Ratio is based on expected growth for EPS. This number is calculated by dividing the P/E ratio by the expected earnings growth rate. This ratio helps investors predict if a company is overvalued based on expected growth estimates.
Trailing P/E ratio
This ratio takes into account a company’s performance for the past 12 months of earnings. It is calculated by taking the current stock price and dividing it by the trailing earnings per share (EPS) for the past 12 months.
Absolute vs Relative P/E Ratios
The absolute P/E is simply the stock price divided by EPS. In other words, it’s the same as the P/E ratio. The earnings-per-share, however could either be a twelve-month trailing or forward-looking figure. The relative P/E compares the current absolute P/E to a past P/Es over a given time period for a company’s stock and is expressed as a percentage. Basically, this number serves to tell investors what percentage of the past P/E the current P/E has reached. This figure can tell investors where a current P/E is in relation to a historical high or low. It’s derived from dividing the current (or absolute) P/E ratio by the historical highest (or lowest P/E.)