Key takeaways
- P/E equals the share price divided by earnings per share: what investors are paying for each dollar of a company's earnings.
- Trailing P/E uses the last twelve months' reported earnings; forward P/E uses estimates, which can turn out wrong.
- Compare P/E ratios within an industry, because typical values vary widely between industries.
- A low P/E can mean a stock has fallen out of favour for good reasons, and a high one can reflect expected growth; neither is a verdict.
- P/E is not meaningful when earnings are negative, and one-off gains or losses can distort it.
FINRA's guide to evaluating stocks calls the price-to-earnings ratio a commonly quoted measure of stock value and describes it simply: calculated by dividing the current price of a stock by its earnings per share, the P/E ratio tells you how much investors are paying for a dollar of a company's earnings. That is all it tells you. Whether that price is sensible depends on things the ratio does not contain.
The calculation
P/E = share price ÷ earnings per share (EPS).
A stock trading at $60 whose company earned $3 per share over the last year has a P/E of 60 ÷ 3 = 20. Investors are paying $20 for each $1 of annual earnings.
FINRA's comparison makes the meaning concrete: if Company A has a P/E of 25 and Company B a P/E of 20, investors are paying more for each dollar earned by A than by B.
Turned upside down, the ratio gives the earnings yield: EPS ÷ price = 3 ÷ 60 = 5%. It is not a cash return: the SEC's beginners' guide notes that companies almost never distribute all of their earnings, usually reinvesting them in the business.
The EPS figure itself comes from the income statement, which the SEC's beginners' guide describes as reporting how much money shareholders would receive for each share if all net income were distributed. Earnings per share explains basic and diluted versions.
Trailing and forward P/E
| Version | Earnings used | Strength | Weakness |
|---|---|---|---|
| Trailing (TTM) | Reported EPS over the last twelve months | Based on actual results | Looks backwards |
| Forward | Analysts' estimates for the coming year | Reflects expectations | Estimates can be wrong |
Always check which one a source is showing. A company with falling earnings can look cheap on trailing P/E and expensive on forward P/E, and the reverse is true for one recovering from a bad year.
A hypothetical comparison. Two companies in the same industry:
| Price | Last year's EPS | Trailing P/E | Next year's estimated EPS | Forward P/E | |
|---|---|---|---|---|---|
| Company A | $40 | $2.00 | 20 | $2.50 | 16 |
| Company B | $30 | $3.00 | 10 | $1.50 | 20 |
On trailing figures, B looks half as expensive as A. On forward figures, the ranking flips, because B's earnings are expected to halve. Neither view is "correct": the forward figure depends on estimates that may be wrong. The point is that one ratio, read alone, can point in opposite directions depending on which earnings it uses.
Why a low P/E is not a bargain detector
Investor.gov's stocks guide describes value stocks as having a low P/E, then adds the important qualifier: their low ratio may reflect the fact that they have fallen out of favour with investors for some reason. Common reasons a P/E can mislead:
- Earnings are expected to fall. The market may be pricing in a decline the trailing figure has not caught up with.
- Earnings are temporarily high. A one-off gain, or a cyclical business at the top of its cycle, inflates EPS and shrinks the ratio.
- Earnings are temporarily low. A one-off charge depresses EPS and makes the ratio look high.
- Accounting choices. Reported earnings depend on estimates and judgments that the company's 10-K discusses; how to read an earnings report explains where.
- Debt. P/E ignores how much a company has borrowed; FINRA lists the debt-to-equity ratio separately for this reason.
Likewise, a high P/E is not automatically "expensive". It can reflect expected growth, which may or may not arrive.
Compare like with like
FINRA's advice is to understand how a ratio compares with the market as a whole and with the company's particular industry, since average ratios vary significantly across industries. Comparing a software company's P/E with a utility's says more about their industries than about either company.
| Comparison | Useful? |
|---|---|
| A company against its own past P/E | Sometimes, if the business has not changed |
| Two companies in the same industry | Yes, the comparison FINRA points to |
| Companies in different industries | Weak, because average ratios vary across industries |
| A loss-making company | Not meaningful: P/E is negative or shown as N/A |
For companies with no profits yet, FINRA notes that the price-to-sales ratio, market cap divided by revenue, can be helpful because it does not depend on profit. Market capitalisation explains the first half of that ratio.
Where P/E fits
P/E belongs to fundamental analysis, which asks what a business is worth, as opposed to technical analysis, which studies price patterns; technical versus fundamental analysis compares the two. Used well, P/E is a starting point for questions, not an answer.
Learn to Trade Stocks Beginner starts its lessons with what a share of ownership means, and you practise with a virtual balance. It is one of our education apps; see the investing basics hub for the related guides.
Good to know
Frequently asked questions
How do you calculate the P/E ratio?
What is a good P/E ratio?
Is a low P/E ratio a bargain?
What does it mean if a P/E ratio is negative or missing?
Sources
- Evaluating Stocks (opens in a new tab)FINRA — accessed
- Stocks – FAQs (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Beginners' Guide to Financial Statements (opens in a new tab)U.S. Securities and Exchange Commission — accessed
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