Price to earnings ratio

The Price to earnings ratio (P/E ratio) is a fundamental valuation metric used by investors and analysts to assess the relative value of a company's stock. It helps determine if a company's share price is high or low compared to its earnings.²⁷ The P/E ratio essentially indicates the dollar amount an investor can expect to invest in a company to receive one dollar of that company's earnings. It is a widely recognized tool within financial analysis and a cornerstone of equity valuation.

History and Origin

The concept behind the Price to earnings ratio has roots in early twentieth-century investment theory, evolving alongside the growth of the modern stock market. While its exact initial usage is difficult to pinpoint, the P/E ratio became a widely adopted tool due to the work of pioneering value investors Benjamin Graham and David Dodd. In their influential 1934 book, Security Analysis, they emphasized the importance of examining a company's earnings power relative to its price, advocating for the smoothing of earnings over several years to account for business cycle fluctuations.²⁴, ²⁵, ²⁶ This approach laid the groundwork for contemporary valuation methodologies and underscored the P/E ratio's role in identifying potentially undervalued or overvalued securities.

Key Takeaways

• The Price to earnings ratio measures a company's current share price against its earnings per share.
• It is a crucial valuation metric, helping investors determine if a stock is overvalued or undervalued relative to its earnings.²³
• A higher P/E ratio can indicate high investor expectations for future growth rate or that the stock may be overvalued.²¹, ²²
• Conversely, a lower P/E ratio might suggest an undervaluation or a lack of strong future growth expectations.¹⁹, ²⁰
• The P/E ratio is best used when comparing companies within the same industry or a single company against its historical performance.¹⁸

Formula and Calculation

The Price to earnings ratio is calculated by dividing a company's current share price by its earnings per share (EPS).¹⁷

The formula is expressed as:

Where:

• Current Share Price (P): The current market price at which a single share of the company's stock is trading.
• Earnings Per Share (EPS) (E): A company's net income divided by the number of its outstanding common shares. EPS is usually calculated using trailing 12-month earnings, providing a historical view.¹⁶

For instance, if a company's stock is trading at $50 per share and its earnings per share for the last 12 months were $2.50, the P/E ratio would be:

This means investors are willing to pay $20 for every $1 of the company's annual earnings.

Interpreting the Price to earnings ratio

Interpreting the Price to earnings ratio involves more than just looking at a single number; it requires context and comparison. A high P/E ratio, such as 25 or 30, often suggests that investors anticipate significant future earnings per share growth.¹⁵ Companies with high P/E ratios are often referred to as growth stocks, as the market is willing to pay a premium for their expected future profitability.¹³, ¹⁴

Conversely, a low P/E ratio, perhaps 5 or 10, might indicate that a company is undervalued or that investors have lower expectations for its future growth. These stocks are sometimes considered "value stocks."¹² However, a low P/E could also signal underlying problems or a struggling business.¹¹

It is critical to compare a company's P/E ratio with its historical P/E, the average P/E of its industry peers, and the broader stock market average.¹⁰ Comparing companies across different industries using only the P/E ratio can be misleading due to varying capital structures, growth prospects, and typical profitability levels. For instance, a technology company might have a much higher P/E than a utility company, but this does not inherently mean the tech company is overvalued or the utility is undervalued.

Hypothetical Example

Consider two hypothetical companies, TechCo and UtilityCorp, operating in different sectors:

TechCo:

• Current Share Price: $150
• Earnings Per Share (EPS): $3
• P/E Ratio: $150 / $3 = 50

UtilityCorp:

• Current Share Price: $40
• Earnings Per Share (EPS): $4
• P/E Ratio: $40 / $4 = 10

In this example, TechCo has a P/E ratio of 50, while UtilityCorp has a P/E ratio of 10. A novice investor might conclude that UtilityCorp is a "better" or "cheaper" investment due to its lower P/E. However, the higher P/E for TechCo could reflect investor expectations of substantial future growth rate in its earnings, common for technology companies. UtilityCorp, on the other hand, likely operates in a more stable, mature industry with lower growth expectations, thus justifying a lower P/E. An investment strategy based solely on a low P/E without considering industry context and future prospects could lead to poor decisions.

Practical Applications

The Price to earnings ratio serves as a fundamental component in various aspects of financial analysis and investment decision-making:

• Stock Valuation: Investors commonly use the P/E ratio to determine if a stock is fairly priced, overvalued, or undervalued.⁹ By comparing a company's P/E to its historical average or to industry benchmarks, investors can gauge market sentiment and expectations.⁷, ⁸
• Industry Comparison: The P/E ratio is particularly effective for comparing companies within the same industry sector. This allows for an "apples-to-apples" comparison, as companies in the same sector often share similar business models, growth opportunities, and risk assessment profiles.
• Mergers and Acquisitions (M&A): In M&A deals, the P/E ratio can be used to estimate the value of a target company. Acquirers often look at the target's P/E multiple relative to their own or industry averages to determine a fair offer price.
• Market Trend Analysis: Aggregate P/E ratios for broad market indices like the S&P 500 are often used to assess the overall valuation level of the stock market. Historically, high market P/E ratios have sometimes preceded periods of lower returns. The Federal Reserve Bank of San Francisco, for example, discusses how P/E ratios fluctuate and are influenced by market conditions.⁶

Limitations and Criticisms

Despite its widespread use, the Price to earnings ratio has several important limitations:

• Does not account for growth: A primary criticism is that the P/E ratio does not inherently factor in a company's earnings growth rate. A high P/E might be justified for a company with strong growth prospects, while a low P/E might be appropriate for a stagnant one. Without considering growth, the ratio can be misleading.⁵
• Inapplicability for companies with no or negative earnings: The P/E ratio cannot be calculated for companies that have negative net income (losses) or zero earnings, rendering it useless for many startups or companies in early growth phases that prioritize reinvestment over immediate profitability.⁴
• Accounting practices: Variations in accounting practices can distort earnings figures, making P/E comparisons between companies difficult. For example, different methods of depreciation or inventory valuation, or the use of non-GAAP earnings, can impact the reported earnings per share.³ This highlights the importance of scrutinizing a company's income statement and balance sheet for a complete picture.
• Ignores debt: The P/E ratio does not consider a company's debt levels, which can significantly impact its financial health and risk assessment. A company with a seemingly attractive low P/E might carry substantial debt, which is not reflected in the ratio.
• Backward-looking nature: The most common form, trailing P/E, uses historical earnings, which may not be indicative of future performance. While forward P/E attempts to address this by using estimated future earnings, these projections are inherently uncertain. As the Financial Times has noted, while useful, the P/E multiple is an imperfect measure.²

Price to earnings ratio vs. PEG Ratio

The Price to earnings ratio is often confused with or used in conjunction with the PEG ratio (Price/Earnings to Growth ratio). While both are valuation metrics, the key difference lies in how they account for a company's growth. The P/E ratio provides a static snapshot of how much investors are willing to pay for each dollar of current or historical earnings. It does not directly incorporate the rate at which those earnings are expected to grow.

In contrast, the PEG ratio addresses a major limitation of the P/E ratio by incorporating a company's expected earnings per share growth rate. It is calculated by dividing the P/E ratio by the expected annual EPS growth rate. This means a company with a high P/E might still be considered reasonably valued if its earnings are growing at a very fast pace, as reflected in a low PEG ratio. For example, a growth stock might have a high P/E of 40, but if its earnings are expected to grow at 40% per year, its PEG ratio would be 1 (40/40), which is often considered fair value. A value stock with a P/E of 10 and a growth rate of 5% would have a PEG of 2 (10/5), suggesting it might be less attractive on a growth-adjusted basis. The PEG ratio provides a more comprehensive perspective, particularly for companies with varying growth profiles.

FAQs

What does a "good" Price to earnings ratio look like?

There isn't a universally "good" Price to earnings ratio. What is considered favorable depends heavily on the industry, the company's growth rate and maturity, and prevailing stock market conditions. A high-growth technology company might have a P/E of 30 or more, while a mature utility company might have a P/E of 10-15. Comparisons should always be made within the same industry and against a company's historical P/E.

Can the Price to earnings ratio be negative?

The Price to earnings ratio is typically undefined or not applicable when a company has negative net income, meaning it is losing money. Since earnings per share (the denominator in the formula) would be negative, a meaningful P/E cannot be calculated. In such cases, other valuation metrics like price-to-sales or enterprise value multiples are often used.

Is a high Price to earnings ratio always bad?

No, a high Price to earnings ratio is not always bad. It often indicates that investors have high expectations for the company's future earnings per share growth. Investors are willing to pay a premium for a company they believe will deliver significant future profits. However, if those high growth expectations are not met, the stock price can fall sharply.¹

How does the Price to earnings ratio relate to dividends?

The Price to earnings ratio and dividends are distinct but related concepts. The P/E ratio reflects a company's earnings power relative to its share price, regardless of whether those earnings are distributed as dividends or reinvested. Companies with high P/E ratios are often growth-oriented and tend to reinvest their earnings back into the business, paying little to no dividends. Conversely, mature companies with lower P/E ratios might pay out a larger portion of their cash flow as dividends, making them attractive to income-focused investors.