Price-to-earning ratio (P/E ratio): What is it and how it works?

What is the price-to-earning ratio (P/E ratio)?

The price-to-earning ratio (P/E ratio) is the relationship of a company’s current share price and its earnings per share (EPS). It shows how many dollars investors should give so they would get one dollar of the company’s earnings. It’s an important number for potential investors, as it helps them determine the value of the company.

Benjamin Graham, a famous investor and the mentor of Warren Buffett, made P/E popular. He said that it was useful to look at its role in the company’s growth rate. It shows if a certain stock is undervalued or overvalued.

Some investors express the P/E ratio value in years. The reason is that they believe it shows how many years you’ll need to pay back the purchase price. So, a P/E ratio of 8 would mean 8 years.

The P/E ratio is one of the most convenient tools for making investment-related choices. Even though it’s not perfect, it helps to understand the basics of a certain business. It’s a good starting point for potential investments.

How price-to-earning ratio (P/E ratio) works?

P/E is a number you get when you divide the price of a share by EPS. For example, when the P/E ratio equals 5, it means that the investor is paying 5 dollars for each dollar the company makes.

If the P/E ratio is high, the investors are giving the company much more money than it’s earning from shares. The higher the ratio, the more investors are paying. This is frequent with start-ups with a lot of investment capital. In general, the P/E ratio helps experts make comparisons within the same industry. This can help investors make better business decisions.

What is a good price-to-earning ratio (P/E ratio)?

There is no simple answer to this. Many say that a lower P/E is always better. But, it’s all related to the industry type and the current market conditions. Investors pick depending on the average P/E ratio within the industry they’re interested in.

When speaking about good P/E ratio, it’s important to make comparisons within the same industry. A company in the health care sector and a tech company shouldn't be set side by side. If you do that, the results you get won’t be of any use.

A low P/E ratio means that the expectations for the earnings aren’t too high. Thus, there are chances that the company will outperform the predictions. That’s why many investors prefer and look for a lower P/E value. A business can also have a low P/E ratio if its share price dropped, but the earnings stayed the same.

Keep in mind that very low P/E ratio values might not be a good sign. It usually means that the business has issues and that its growth prospects are poor. You’ll get an idea of what “very low” is in a specific situation when you look at the industry average.

A high P/E ratio suggests that experts expect a company to earn plenty in the future. This happens with small companies, start-ups, or fast-growing markets. Sometimes, it can mean that a stock is overpriced.

In the end, it comes down to your personal investment style and business decisions. The P/E value only, can’t guarantee that an investment is good and profitable.

The most common types of P/E ratio

When it comes to different kinds of P/E ratios, the forward and trailing are the most popular. Both help estimate a company’s performance, but the difference is the perspective. One tries to predict the future, and the other analyses the past.

Forward P/E

The forward P/E ratio is the number you get when dividing the present share price by the estimated future EPS of the company. That’s why it’s also called the estimated P/E. In a nutshell, it calculates the P/E ratio by using future predictions for net earnings. Those estimates come from the company’s future earnings guidance. Forward P/E ratio is usually calculated for the following 12 months or full-year fiscal period.

The forward P/E ratio is more relevant than the past ones. Investors often use it to form an idea of the upcoming performance and growth rate of the company. They don’t completely rely on it, as it’s still a forecast.

Trailing P/E

Unlike forward P/E, trailing P/E ratio uses the actual earnings in the recent past, not predictions. It divides the present-day share price by the EPS during the past 12 months. When experts refer to the P/E ratio without specifying which one, they’re most likely talking about trailing P/E.

In a way, it’s more reliable than the estimated P/E ratio, because it’s based on real reports. But, the past results can’t always help predict future behavior. Sometimes it’s best to combine the two and try to get the most precise estimate possible.

Absolute vs. relative P/E

Another distinction that analysts use is the absolute vs. relative P/E ratio. Absolute P/E represents the current price-to-earnings and relative P/E compares that to a certain benchmark.

Absolute P/E

Absolute P/E is the relationship between the inventory value and forward P/E. In some cases, experts use trailing EPS instead of forwarding P/E. You get trailing EPS by calculating the company’s earnings during a period in the past.

The absolute P/E ratio demonstrates how much investors want to pay for a dollar of earning. It has many uses and it’s helpful to look at it when making investment decisions. As the earning power and interest rates rise, so does the absolute P/E ratio.

Relative P/E

The relative P/E ratio compares the present P/E ratio to one of two things. The first option is a certain benchmark, and the second are the previous P/E values of the company. Relative P/E calculates whether the present P/E has changed from the past values.

It helps determine if the P/E ratio of a company is fair in relation to current market circumstances. Also, it allows experts to draw parallels with other companies from the same industry. If the relative P/E equals 1, that means that the company has the same value as others in its group.

The more popular a company grows, the higher its relative P/E ratio gets. So, when people become interested in an industry or business, its relative P/E ratio rises.

P/E ratio example

Let’s say that the P/E ratio of a company is 4. That means that investors pay 4 USD for each dollar of the company’s earnings.

For example, this Yahoo Finance article lets you in on some low P/E stocks from May 2020. It says that Apple’s P/E ratio is 24, which means that investors pay 24 USD for one dollar of Apple’s earnings. This is rather cheap for a company of its power. But, Delta Airlines has a P/E of only 4, due to the coronavirus pandemic. The difference is enormous. So, the number can help people decide whether it’s a good time to make an investment or not.

P/E ratio formula

You won't need a special P/E ratio calculator to determine its value. If you know the company’s share price and the EPS figure, it's quick and simple. You only have to divide the current share price by the EPS and the result is the P/E value. So, this is what the formula looks like:

P/E ratio = Current share price / EPS

If a company’s current share price is 200 USD and its EPS is 20 USD, the P/E ratio is 200/20. For every dollar of the company’s EPS, the investor will give 10 USD.

P/E ratio stock

Some of the most interesting stocks to keep track of are those of successful and big companies. Their P/E ratios are usually high because they are expected to earn even more in the future. The US stock market uses an index called the Standard & Poor's 500 Index (S&P 500) to track the performance of 500 large companies.

They trade on the NASDAQ or the New York Stock Exchange. Many think this is a great representation of the US stock market. The P/E ratio of the S&P 500 certainly helps investors learn the average value of US stocks. This article on the ABC News website shows you how to calculate the daily S&P 500 P/E ratio.

P/E ratio limitations

Even though the P/E ratio value is common in the investment world, it’s not a number you should 100% rely on. You should base your decisions on a couple of different factors. Some of them are earnings charts, sales figures, or dividend rates.

Perhaps the main limitation of P/E is the fact that each company reports its own earnings. This could lead to deception, whether on purpose or by accident. One possibility is that the company is hiding costs and thus inflating its earnings.

Another one could be the accounting method the company is using. If the investor is not familiar with it, it will take time to analyze. This might make them believe that something sketchy is going on when there are many valid methods in use. In both cases, the P/E value won’t give all the necessary information.

Also, even though some investors avoid companies with high P/E ratios, they don’t have to mean money loss. Sometimes, a high P/E ratio means the company invested a lot in the business. That is not a bad thing, but on paper, it might seem that way.

Another downside is that the P/E ratio can’t guarantee the future of business growth. A company could seem like a good investment because its stock is not expensive. However, if its revenue is shrinking over time, it could end up being expensive. But, if the stock is expensive, but the revenue is growing, investing is a good call. The P/E ratio value won’t help with predicting earnings.

P/B ratio

Experts use the P/B ratio to compare a company’s present market price to its book value. Book value is the value according to the balance sheet. The calculation is simple: the nominator is the stock price per share and the denominator is the book value per share (BVPS).

Determining a company’s value based on the P/B ratio is tricky, but it can help you find hidden treasures. If P/B value is low, it can mean two things. First, the stock is low in value, and second, that the company’s not functioning well. In conclusion, P/B can help, but it’s best used in combination with other factors.

EPS ratio

Earnings per share (EPS) shows how much net income every share of common stock has earned during a period of time. So, it’s a result of a simple division. Divide the net earnings available to common shareholders by the average outstanding shares. EPS is an indicator of a company’s financial well-being. It displays its ability to produce net profits for shareholders.

It’s also useful for comparing a company to others in the same industry. This way it’s easy to see if the company is performing better or worse than its peers. EPS is necessary for determining the P/E ratio.

There are a few ways to calculate EPS. You’ll need a couple of things for the most common and basic one. Those are the period-end number of common shares, the net income, the preferred dividends, and the average number of shares outstanding.

The finished formula is this:

EPS ratio = (Net income - Preferred dividends) / Weighted average number of shares outstanding

A more precise and diluted version would also include convertible shares and warrants under outstanding shares. When used in combination with other ratios, EPS is one of the most relevant financial indicators.

P/E ratio for tech companies

Tech companies, and tech start-ups in particular, usually have high P/E ratios. That’s because the investors are paying much more per share than the business is actually making. The popularity of the industry ensures a high P/E. Another factor is that some tech companies pay their employees in stock, instead of cash. Giants like Microsoft and Facebook all have their P/E above 30.

Intelligent investor P/E ratio

One of the things that made the P/E ratio popular is “The Intelligent Investor”. This is a book by Benjamin Graham, the “father of value investing”. It’s a classic in the finance world and anyone who's interested in investing comes by it at some point. For a long time, it was a rule book when dealing with P/E.

Graham believes that stock with P/E value over 15 is expensive. He advised investors to look for a stock with P/E values of 9 and less. Many considered this to be true for a period of time, but today things have changed.

Without a doubt, this book made a huge change when it comes to awareness about P/E. It influenced experts and changed the investment world. But, not everything from the book still stands today. The market in 1949, when Benjamin Graham wrote the book, was different than today’s. Some later editions of the books warn that P/E shouldn’t be the only thing to rely on.