What is the price-to-earnings ratio?

To see how P/E works, let's look at a real-world example.

Take Apple Inc. in 2013. The company's earnings were stable at the time after earlier growth, but many investors were concerned that Apple was losing its edge on the smartphone market to new competitors. As a result, Apple's stock price kept falling in the first half of 2013 and its P/E ratio dropped to a decade-low 9. As this was below the P/E ratio of some of its main competitors, some considered Apple stock a good buy opportunity at the time. Now fast-forward to early 2020. Apple's earnings had roughly doubled since 2013, but the stock price increased by almost sixfold in the period, rising especially in 2019 as investors put faith in the company's new products, and in general flocked to stocks ahead of the looming recession. This boosted Apple's P/E ratio to 25, making some analysts wonder whether the stock had become overpriced.

You can also calculate a PE ratio for an entire market or equity index, such as the S&P 500. To give you an idea about some recent highs and lows, let's see two examples.

In May and June 2009, in the midst of the Great Recession, the P/E ratio of the S&P 500 spiked to a record-high 122. This happened because earnings bottomed out as the recession reached all sectors of the economy, but stock prices were already on the way up in hopes of a coming recovery; hence the high P/E. By contrast, the P/E ratio of the S&P 500 fell to a 22-year low 13 in September 2011. Company earnings were as strong as ever, having fully recovered from the Great Recession; however, concerns over the European debt crisis sent stock prices lower, resulting in a low P/E ratio.

So what is a "normal" P/E ratio? As we'll explain later, it depends on many things. For the record, the historical average P/E ratio of the S&P 500 index is about 15. It moved in the 10-25 range for much of its history, clocking in just above 21 as we are writing this piece in late May 2020.

As you can see it below, P/E ratios differ wildly among industries. (Trailing P/E looks at the share price relative to past earnings, while forward P/E measures the share price relative to forecasted earnings per share - we'll learn more about these in the following chapters.)

How to calculate the price-earnings ratio? The "price" part is fairly straightforward: just go to any finance website or your online broker to check the current market price.

Figuring out the "earnings" part is a bit more tricky, though. First of all, when we say earnings, what we really mean is earnings per share, or EPS, for a one-year period. This can be either the most recent four quarters or a forecast for the next four quarters.

Net earnings is a relatively good indicator of a company's value-generating power, but it can be distorted in several ways, in turn giving you a potentially misleading P/E ratio.

• Make sure the EPS figure you're looking at excludes extraordinary items. These are one-off events in the company's history – like a big fine or profits from the sale of an asset – that have an impact on the current bottom line but likely won't be repeated year after year and do not influence the company's inherent value.
• Whenever possible, you should focus on EPS from continuing operations. This figure excludes profits from operations – e.g. a chain of stores or an overseas factory – that the company has just sold or closed; making it a better metric of the company's current (and future) value.

The "per share" component of EPS is also not as self-evident as it seems, as sometimes there is a possibility that the company will issue new shares in the coming year (e.g. via convertible bonds). This would slightly lower EPS, as the same profit is distributed among more shares. Including such theoretical new shares in the earnings-per-share formula will give us diluted EPS.

Conversely, if the company buys its own shares on the stock exchange and then cancels them (a move called share buyback), your earnings per share will rise, as the same profit is divided among fewer shares.

The P/E ratio itself comes in several variations, differing mainly in how they treat earnings timeframes or earnings volatility.

The most important distinction is between trailing and forward P/E. Trailing P/E (also appearing as TTM, or trailing-twelve-months P/E) looks at the share price relative to past earnings, invariably meaning the most recent four quarters. By contrast, forward P/E (also called leading P/E) measures the share price relative to forecasted earnings per share, typically for the coming four quarters.

• The advantage of trailing P/E is that we have exact information on past earnings, giving us a precise P/E. Its disadvantage, as broker disclaimers will keep reminding you, is that past performance is not indicative of future performance; and it's the future performance of a company that you are buying into when you buy a stock.
• Forward P/E will give you information on just that. However, its disadvantage is that forecasts, whether provided by the company itself or by independent analysts, are by their nature uncertain and imprecise. Again, both metrics have their own merit; the most important thing is to know which one you're looking at, and use it accordingly.

As we will see later, P/E is not suited to all companies and situations equally. For example, P/E ratios for high-growth companies such as tech startups can be dizzyingly high, often in the three digits. Is the market getting carried away? Or is this company really booming, therefore justifying the price? This is where the price-to-earnings-to-growth, or PEG ratio comes in. It's very simple: just divide the P/E ratio by the expected percentage rate of earnings growth in the next year.

Let's say we have a company with a P/E ratio of 110 that is expected to double its profits in the next 12 months. Its PEG ratio is 110 divided by 100%, equal to 1.1 – a perfectly normal figure.

As a rule of thumb, a PEG below 1 may signal that the stock is undervalued, while a PEG significantly above 1 may be a hint that the stock is overvalued. You can also apply PEG to past earnings and growth rates.

Does all this sound intimidating? Don't worry – you are rarely required to calculate P/E or EPS by hand, as it will often be displayed on finance websites or on your broker's trading platform. This introduction was intended just to help you make sense of various P/E quotes you may encounter on these sites. PEG? Diluted EPS? TTM P/E? We now have you covered.

In case you want to calculate the P/E ratio yourself, there are several online calculators out there to assist you.

Now that we know what a P/E ratio is, let's see how to use it when investing in stocks. You may think it's easy: if a stock's P/E is low, it means it's undervalued and you should buy it; and if it's high, it's overvalued and you should avoid or sell it, right? Not so fast. First of all, there is no objective, standalone criteria that will tell you if a particular P/E ratio is low or high – it all depends on context, including what industry we're talking about; whether it's a fast-growing startup or a mature business; or what the general market situation is and how the economy is performing. And even if, after various comparisons, we conclude that a particular P/E ratio is low, it still may not signal a buying opportunity.

P/E in a market context

One way to make sense of a price-earnings ratio is to put it in a market context. When you buy a stock, either as a long-term investor or as a short-term trader, you basically buy into the company's future earnings potential. Looking at it from that perspective, the P/E ratio tells you how much you have to pay for $1 of a company's annual earnings. To calculate your annual "return" on this investment, just reverse the P/E ratio and divide earnings-per-share by the stock price – this is called the earnings yield.

If stock XYZ trades at $50 and its EPS is $2, it will have a P/E ratio of 25 and an earnings yield of 0.04, more conveniently expressed as 4%.

When investors are looking for investment targets, they won't just weigh one stock against another. One basic approach is to compare a stock's "yield" to that of US government bonds, which come as close to a risk-free investment as they get. Now let's suppose that US Treasury bonds currently have a yield of 4%. In this case, would you buy stock XYZ, which is inherently more risky but offers the same 4% yield? You most probably wouldn't. As the stock is not attractive in this market environment, its price and therefore its P/E ratio will fall. By contrast, if US bond yields, or general interest rates across the economy are very low, then even a stock with a low earnings yield, i.e. a seemingly high P/E ratio, may be considered a good buying opportunity.

Dividend and P/E

We used a stock's "yield" in the above example in the theoretical sense, because as a stock trader, you will primarily look to profit from increases in the share price (driven by earnings growth), rather than have direct access to a company's full earnings each year. However, there is in fact a way to directly benefit from a company's earnings, through dividend. Many companies will pay out a certain percentage of their annual profit to shareholders as cash dividend. This percentage is called the payout ratio.

Let's go back to stock XYZ, and say that it has a payout ratio of 60%. This means a dividend payment of $1.2 per share. If you bought the stock for $50, you will reap a cash yield of $1.2 divided by $50, equal to 2.4% – this is called the dividend yield.

As this is an actual cash payment, it is more directly comparable to other income forms, such as coupon payments from a bond or rental income from an apartment; though of course their risk levels and therefore yield expectations will differ.

Not all companies will pay dividend, though. It is more common among long-established companies with stable profits such as consumer-goods producers, utilities, or telcos. Some of these companies will have a long-term dividend policy, often including a fixed payout ratio; you can find this information in their public filings or earnings reports. By contrast, dividend payment is rare among younger, fast-growing companies in IT and other emerging industries, where companies usually prefer to reinvest profits – assuming they generate any – into new products, services or staff.

Ready to take the next step? Check out our handy guide on how to buy shares.

Unfortunately, the P/E ratio is not well suited to all companies or situations. Just take that last sentence from the paragraph above – there will always be companies that generate a loss or just barely break even. In such cases, P/E would yield a useless negative number, or no number at all if earnings are zero; even though the company may be a perfectly legitimate investment target that just happens to be in its early growth phase, or hitting a rough patch along with the rest of the economy. Below are some other possible pitfalls of using the PE ratio.

Why it's difficult to determine "good" P/E

One limitation of the P/E ratio is that it cannot really be used to compare stocks across industries. This is because different industries are evolving and making money in different ways, resulting in varying growth prospects and profit margins. Manufacturers rely on expensive machinery, raising their capital costs; retailers simply buy products and re-sell them at thin but stable margins; IT or biotech firms rely mostly on brain power to reap profits on fast-growing but risky markets; while banks' earnings depend largely on loan rates defined by the general interest-rate environment.

Such differences can result in substantial differences in average P/E among various sectors. For example, on US markets, the average forward PE ratio in January 2020 was 7 in the coal industry; 12 for banks; 16 for specialized retailers; 21 for auto and machinery makers; 32-35 for oil companies; 71 for healthcare products; and 77-101 for software developers. So you are better off using the P/E ratio only for apples-to-apples comparisons within one sector.

Another reason that an "ideal" P/E ratio remains elusive is that it also depends on the general market environment. As we saw in our discussion of the market context, a given P/E ratio can be attractive or unattractive depending on current government bond yields. And that's just looking at one specific market; different countries have different risk-free interest-rate levels, making cross-border P/E comparisons difficult.

Value traps

Let's say you come across a stock and conclude, after considering all that we've discussed so far, that its P/E ratio is low. Does this mean that the stock is undervalued and therefore a good buying opportunity? Not necessarily. If you ever shopped for anything in real life, you will know that some things are cheap for a reason; stocks are no different. A situation where an enticingly low valuation turns out to be a not-so-good investment is called a value trap. Often, a low P/E simply means that the market doesn't believe in the company's future earnings growth, or believes that the company is too risky. There could be several reasons behind this – perhaps the company is working in an industry or making a line of products that are becoming obsolete; perhaps it has new and aggressive competitors; perhaps it is caught up in a scandal and facing lawsuits; perhaps its credit rating has been lowered amid financial problems. So whenever you see a low P/E ratio, it is worth taking a closer look at the company's fundamentals and its individual risk factors.

The PE ratio is also an imperfect tool for cyclical industries – such as the auto industry or commodities – where earnings depend just as much on longer-term economic cycles as on companies' business skills and product quality. A company in a cyclical industry that is enjoying high profits at the peak of the cycle can also turn into a value trap.

Let's say an automaker makes $4 EPS at the top of the cycle, and trades at $60, for a P/E ratio of 15; while it makes $2 EPS near the bottom of the economic cycle, and trades at $50, for a P/E of 25. If you buy the stock for $60 focusing on the low P/E ratio alone, the value of your investment will actually fall as the economic cycle turns.

This is called a peak earnings trap.

What is a good P/E ratio?

It is impossible to say, as it depends on the industry and the state of the overall economy, among others. Broadly speaking, P/E should be roughly commensurate to earnings growth – so high-growth sectors and companies are likely to have higher P/E ratios. See how P/E ratios compare among various sectors.

How to calculate the P/E ratio?

It's easy: just take a calculator and divide the current stock price by the company's latest (or forecasted) annual earnings per share. It is also often featured on finance websites or brokers' trading platforms.

What is a high P/E ratio?

It is likewise difficult to say. A seemingly high P/E ratio can signal that a stock is overvalued, but also that it is an exciting stock with strong growth potential. High P/E ratios can also result from low bond yields, as investors gravitate to the stock market instead, pushing up stock prices.

Is a low P/E ratio good? How do you know if a stock is undervalued?

A low P/E ratio doesn't always mean an undervalued stock; it could simply mean a bad one. If a stock has a low P/E ratio, it's a good idea to look at the fundamentals to see if there are any operational or market risks that threaten the company's earnings potential.

What is the P/E ratio of the S&P 500 today?

It is 21 as of May 21, 2020, somewhat above its historical average of ca. 15.

What is the average P/E for specific industries in the US?

As you can see in the table below, P/E ratios differ wildly among industries. (Trailing P/E looks at the share price relative to past earnings, while forward P/E measures the share price relative to forecasted earnings per share)

Source: Aswath Damodaran, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pedata.html