A price-to-earnings ratio (P/E) is the price of a company's share divided by the earnings per share to create a comparison. A high P/E ratio occurs when a company's P/E ratio is significantly higher than the average of other companies in a similar industry.
Retail giant Amazon had an average P/E of 144.59 in April 2021. This compares to a median of 22.72 within the retail industry. So what does this mean? Amazon presents one of the limitations with P/E because the market sees the business as a disruptive tech company with enormous growth potential ahead. While this growth may or may not materialize in the future, in the past some investors missed Amazon's huge rally thinking the company was overvalued on a P/E basis.
As shown by Amazon's example, even the most seasoned investors find it difficult to make judgments based solely on a company's P/E.
High P/E Ratio
High P/E or low P/E?
Based on the formula, price per share divided by earnings per share, one would logically assume that a low P/E ratio is good. But, as seen with Amazon, it is not hard for a company to be doing well and have an elevated P/E.
A high P/E can indicate a few things. It could mean that the company’s shares are overvalued and that you need to pay too much for the stock. On the other hand, it could also mean that earnings are projected to grow or that the current year's earnings were lower than what you can normally expect going forward.
Accordingly, a company's P/E ratio alone is not enough to determine how it will perform in the future. There are many other factors to consider when investing.