What Is Price-to-Earnings (P/E) Ratio?

UTC by Beatrice Mastropietro · 7 min read
What Is Price-to-Earnings (P/E) Ratio?
Photo: Depositphotos

The Price-to-Earnings (P/E) ratio is a valuation metric used to compare its share price with its earnings per share. Read on our guide to learn how to calculate it and how to analyze the results.

Price-to-Earnings (P/E) ratio is a popular way to assess a company’s value relative to its earnings. Expressed as a numerical value, it shows the multiple times that stock price traded compared to one year’s net income for the same company. In simple terms, the Price/Earnings ratio means how much you would pay for $1 in earnings from this business.

The formula used for calculating P/E is P/E = Price per Share / Earnings per Share.

For example, if a company’s shares cost $30 and earned $10 in net income for each share, investors are willing to pay three times earnings or P/E = Price per Share / Earnings per Share. In this case, P/E is equal to 30/10=3.0.

What is the maximum permissible value of a P/E ratio? If a stock sells at very high multiples of its earnings, it may suffer serious stock price deterioration. In general, investors avoid paying more than 25 times their companies’ earnings.

How P/E Ratio Appeared

Accountant Robert Shiller invented the Price-to-Earnings ratio back in the 1960s. He had been looking at stocks and various financial data since he was a teenager. He did it while studying economics and accounting at Yale University in 1968, and it was a part of investing lore for some time. Shiller’s P/E ratio was created to see if stock prices were overvalued or undervalued.

A Price-to-Earnings (P/E) ratio measures the price paid per share relative to earnings (EPS). A high P/E means that investors are paying more for each dollar of earnings, while a low P/E indicates that they are willing to pay less. The ratio helps investors determine whether to buy or sell a stock by identifying how wildly prices are moving.

How the P/E Ratio Works

A high P/E ratio often indicates two things. Firstly, investors expect rapid growth in the future. Secondly, the company might have performed poorly recently. ​

On the other hand, a low P/E could indicate the following: the business is doing poorly, the company has no prospects for growth over the next 12 months, or it is too expensive to run the company. So, retailers are typically classified as “value stocks” because they have low p/e ratios. Their stock prices are trading at a discount to their fair value based on the earnings they will produce over time. The opposite is known as “growth stocks”. They have higher P/E ratios since investors have already priced good growth prospects into the share price.

One way to determine if information about the P/E ratio makes sense is to compare it against publicly traded industry peers as well as against past data for each company. Notably, certain sectors tend to trade at higher price-to-earnings multiples than others, but this can change over time. For instance, financial services companies generally trade with lower valuations because of risk-related factors.

Algebraically, the Price-to-Earnings ratio looks like E / Price = P / E. The formula determines how much you would pay for $1 in earnings from this business. If the company earned $1 in profit in 2020 and its current share price is $10, you could say that the P/E ratio was 10. Price-to-Earnings Ratio can also compare companies operating in the same sector and those producing similar goods and services. It helps investors determine whether to buy or sell a stock by identifying how wildly price or earnings are moving, thus telling if their price is good value for earnings.

It is important to remember that price and earnings values and price and earnings ratios change because of overall market conditions, such as the bullishness of the economy, investors’ risk appetite, interest rates, inflation, etc. Besides, suppose if you look at the price compared with earnings over time. In that case, the Price-to-Earnings ratio varies because earnings change over time to get higher profits resulting from economic growth or decreased earnings due to recession. The price-to-earnings “ratio” shows that what people are willing to pay might differ from the value realized by those earnings. P/E ratio analysis helps investors decide how much this difference is worth.

P/E Ratio Calculation

The share price divided by its earnings per share will give you the P/E ratio. You can calculate it by multiplying the stock’s current market price by one plus its earnings per share divided by the number of outstanding shares. Market capitalization is usually used for this purpose since it considers all outstanding shares, including employee holdings or unissued options.

Also, note that investors may not be interested in just one year of earnings. Therefore, some analysts use an average EPS figure to calculate P/E ratios on two-, three-, five-, 10-year forward multiples and other intervals. In general, a P/E ratio is a good tool for valuations within a given industry. However, it may not be useful in comparing two stocks from different industries. This is because one company may have more debt than the other. Both earnings may vary due to many other factors like inflation or economic conditions.

If we apply this to cryptocurrencies, there is no price-earnings number. Instead, we need an exchange rate (Price-to-Earnings Ratio). For example, we can take daily Bitcoins (BTC) earned by miners as their earnings and market capitalization as the prices. Price is the total value of all coins mined till date divided by total supply. Earnings are the daily reward divided by the hash rate per day. The price-earnings ratio is calculated by dividing the price by earnings.

You can also use the diluted EPS based on the current share price. Instead of using after-tax earnings, you could deduct one-time diluted shares from the total number of shares outstanding in 12 months to determine diluted EPS. Let’s assume there are 10 million common stocks and 5 million dilutive securities, including warrants and convertible preferred stock. This means a total of 15 million possible shares outstanding for this calculation. In addition, let’s say that company earned $10  for those twelve months. For example, diluted EPS would be 10 divided by 15, which equals 66 cents per share. We use diluted EPS over regular EPS because it considers all potential shares that could exist instead of just common stocks. So if the company paid dividends or had employees who converted their options into common stocks, it would find reflection in diluted EPS instead of regular EPS.​

P/E Ratio in Use

The price-to-earnings (P/E) ratio is one of several price ratios that investors use to gauge whether a stock’s current price is cheap or expensive. The P/E ratio relates the share price to earnings per share (EPS), indicating how much profit you make on each investment dollar. Many investors focus on companies with low P/Es since they believe these stocks offer more bang for their buck. Other analysts suggest looking at high P/Es, including Microsoft Corp (NASDAQ: MSFT) and Google LLC (NASDAQ: GOOG). Whichever camp you’re in, it pays to understand what value this ratio imparts. To find out, read on.

Unlike most price ratios, P/E relies on earnings. Stocks with high P/Es have higher prices than their actual earning power would justify. In other words, they are riskier to keep the share price stable. Companies with low P/Es offer investors a chance to earn more returns each year, raising dividends by at least 10%.

Rising or falling P/Es can indicate whether a company recently had good news about its future earning power or bad news that sent prices downward temporarily until more information becomes available. It’s normal to see a 30-40% rise or drop in PE ratios after positive and negative announcements like these. When evaluating new stocks that haven’t announced earnings, look at analysts’ projections. Their estimates usually include consensus figures from several investment banks and brokers on Wall Street.

Conclusion

The Price-to-Earnings ratio is one of the most common ways of valuing stock prices. It compares a company’s profits or losses with its current share price. Investors use P/Es as a quick way to compare different stocks. The ratio can help you find companies that are currently undervalued in comparison to their earning power or overvalued if the P/E ratio is much higher than 1. A high P/E ratio can mean that the market expectations of future growth are very high.

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FAQ

What is Price-to-Earnings ratio?

Price-to-Earnings (P/E) ratio is a popular way to assess a company’s value relative to its earnings. Expressed as a numerical value, it shows the multiple times that stock price traded compared to one year’s net income for the same company. In simple terms, the Price/Earnings ratio means how much you would pay for $1 in earnings from this business.

What are the issues involved in Price-to-Earnings ratio?

The price-earnings ratio compares the current market price with its net income per share.

How to calculate P/E ratio?

The share price divided by its earnings per share will give you the P/E ratio. You can calculate it by multiplying the stock’s current market price by one plus its earnings per share divided by the number of outstanding shares. Market capitalization is usually used for this purpose since it considers all outstanding shares, including employee holdings or unissued options.

How to analyze the results of P/E ratio calculation?

The price-to-earnings (P/E) ratio is one of several price ratios that investors use to gauge whether a stock’s current price is cheap or expensive. The P/E ratio relates the share price to earnings per share (EPS), indicating how much profit you make on each investment dollar.

The ratio can help you find companies that are currently undervalued in comparison to their earning power or overvalued if the P/E ratio is much higher than 1. A high P/E ratio can mean that the market expectations of future growth are very high.

How to use the P/E ratio to evaluate stocks?

For example, if a company has earnings of $10 billion and has 2 billion shares outstanding, its EPS is $5. If its stock price is currently $120, its PE ratio would be 120 divided by 5, which equals 24. 

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