The price-to-earnings ratio, also known as the P/E ratio, is one of the most commonly used stock valuation metrics, and it is important for any investor to understand. In this article, we’ll take a closer look at what the P/E ratio is, how to calculate it, and how to use it as part of your investment analysis.
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Understanding the P/E ratio
Understanding the P/E ratio
The P/E ratio, or price-to-earnings ratio, is a metric that compares a company’s net income to its stock price. It can be an excellent tool when analyzing stocks and can help investors get a sense of whether a stock is a good value or expensive.
As the name implies, the P/E ratio is calculated by taking the current share price of a stock and dividing by its earnings per share over a one-year period. For example, if a stock trades for $40 per share and earned $2 per share in the past year, its P/E ratio would be 20.
You may hear the P/E ratio also referred to as the P/E multiple or earnings multiple, and it’s important to realize that these terms are often used interchangeably and mean the same thing.
There are several different ways to calculate the P/E ratio, with the two most common being the trailing P/E and the forward P/E. A stock’s trailing P/E is calculated by using its past four quarters’ earnings, while the forward P/E is calculated by using the consensus projections, or the company’s own guidance, for the next 12 months of earnings.
Why is it important?
Why is the P/E ratio important?
The P/E ratio is important because it is a valuation metric that is useful for comparing different investment opportunities to one another. It can be a useful tool when trying to identify undervalued stocks, and it can help you avoid overpaying for stocks as well.
How to use it
How to use the P/E ratio
The most effective way to use the P/E ratio is to compare the valuations of businesses in the same industry at similar stages of maturity. For example, you might use the P/E ratio as part of an analysis comparing Target (TGT -5.34%), Costco (COST 0.64%), and Walmart (WMT -1.91%).
It is also worth pointing out that the P/E ratio doesn’t work on companies that aren’t profitable. There are other valuation metrics that can be applied to early-stage growth companies, but the P/E ratio isn’t one of them.
No valuation metric can tell you if a stock is an attractive investment opportunity all by itself, and the P/E ratio is no exception. For example, the stock of a faster-growing business should have a higher P/E ratio than a slower-growing one, all other factors being equal. So the P/E ratio is best used as one piece of the puzzle, in combination with earnings growth, cash and debt levels, gross and net profit margins, and other figures.
Finally, if a stock has a P/E ratio that is much lower than its peers, it can be a red flag that is worthy of further investigation. Companies with P/E ratios that seem too good to be true often have declining sales, poor balance sheet quality, or another underlying reason for the seemingly cheap valuation.
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Example
Example of using the P/E ratio
Let’s take a look at a real-world example of calculating the P/E ratio. As of Feb. 6, 2023, Apple (AAPL 0.69%) traded for $154.50. Over the past four quarters, Apple earned $5.90 per share. So we can calculate its trailing P/E ratio as follows:
So Apple trades for 26.2 times its trailing-12-month earnings. If we wanted a more forward-looking metric, we can use Apple’s projected earnings over the next 12 months, which are $6.23 per share. If we use this, our forward earnings calculation looks like:
Now let’s say that you’re trying to decide between Apple and Microsoft (MSFT -2.07%). On the same date, Microsoft traded for $255.12. Its trailing-12-month earnings were $8.99 per share, so its trailing P/E ratio could be calculated as:
Apple’s trailing P/E is 26.2, while Microsoft’s is 28.4. Based on the P/E ratio alone, Apple appears to be the cheaper stock. However, as mentioned above, it’s important to understand the P/E ratio is just one metric that should be used in stock analysis and doesn’t tell the whole story.
So when conducting an analysis of two companies like this, the best practice is to use the P/E ratio along with other metrics for both companies to develop a thorough comparison of the two investment opportunities.
Matthew Frankel, CFP® has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple, Costco Wholesale, Microsoft, Target, and Walmart. The Motley Fool has a disclosure policy.
FAQs
As the name implies, the P/E ratio is calculated by taking the current share price of a stock and dividing by its earnings per share over a one-year period. For example, if a stock trades for $40 per share and earned $2 per share in the past year, its P/E ratio would be 20.
What is an excellent PE ratio? ›
Typically, the average P/E ratio is around 20 to 25. Anything below that would be considered a good price-to-earnings ratio, whereas anything above that would be a worse P/E ratio.
What does Warren Buffett say about PE ratio? ›
Warren Buffett wrote “Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.”
How much PE ratio is good to buy a stock? ›
Average PE of Nifty in the last 20 years was around 20. * So PEs below 20 may provide good investment opportunities; lower the PE below 20, more attractive the investment potential.
What is the PE ratio in layman's terms? ›
The Price to Earnings Ratio (P/E ratio) compares a company's stock market price with its earnings per share (EPS). It's a key valuation metric indicating if a stock is overpriced or underpriced. The 'P' in the numerator represents the current market price, while the 'E' in the denominator represents the EPS.
What is the PE ratio of a Tesla? ›
P/E ratio as of September 2024 (TTM): 63.4
According to Tesla's latest financial reports and stock price the company's current price-to-earnings ratio (TTM) is 63.4223. At the end of 2022 the company had a P/E ratio of 30.6.
What is a healthy PE ratio range? ›
What Is Considered to Be a Good PEG Ratio? In general, a good PEG ratio has a value lower than 1.0. PEG ratios greater than 1.0 are generally considered unfavorable, suggesting a stock is overvalued. Meanwhile, PEG ratios lower than 1.0 are considered better, indicating a stock is relatively undervalued.
What is Berkshire Hathaway current PE ratio? ›
As of today (2024-09-08), Berkshire Hathaway's share price is $459.42. Berkshire Hathaway's Earnings per Share (Diluted) for the trailing twelve months (TTM) ended in Jun. 2024 was $31.41. Therefore, Berkshire Hathaway's PE Ratio (TTM) for today is 14.63.
What is honest PE ratio? ›
P/E ratio as of September 2024 (TTM): -6.48
According to The Honest Company's latest financial reports and stock price the company's current price-to-earnings ratio (TTM) is -6.48393. At the end of 2022 the company had a P/E ratio of -5.57.
What is Warren Buffett's golden rule? ›
"Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1."- Warren Buffet.
The justified P/E ratio is used to find the P/E ratio that an investor should be paying for, based on the companies dividend and retention policy, growth rate, and the investor's required rate of return. Comparing justified P/E to basic P/E is a common stock valuation method.
What is the current PE of the S&P 500? ›
S&P 500 P/E Ratio is at a current level of 27.45, up from 24.79 last quarter and up from 23.46 one year ago. This is a change of 10.76% from last quarter and 17.03% from one year ago. The S&P 500 PE Ratio is the price to earnings ratio of the constituents of the S&P 500.
What is the PE ratio of Apple? ›
As at Sep 11, 2024, the AAPL stock has a PE ratio of 33.79. This is based on the current EPS of $6.59 and the stock price of $222.66 per share. An increase of 16% has been seen in the P/E ratio compared to the average of 29.0 of the last 4 quarters.
What is a PE ratio for dummies? ›
Price to earnings ratio, or P/E, is a way to value a company by comparing the price of a stock to its earnings. The P/E equals the price of a share of stock, divided by the company's earnings-per-share. It tells you how much you are paying for each dollar of earnings.
What is the most common PE ratio? ›
To give you some sense of what the average for the market is, though, many value investors would refer to 20 to 25 as the average P/E ratio range.
What is a fair PE ratio? ›
The average market P/E ratio is 20-25 times earnings. Estimated earnings can be used to calculate the projected P/E ratio.
Is 30 a good PE ratio? ›
A P/E of 30 is high by historical stock market standards. This type of valuation is usually placed on only the fastest-growing companies by investors in the company's early stages of growth. Once a company becomes more mature, it will grow more slowly and the P/E tends to decline.
Is a 50 PE ratio good? ›
If a stock's price rises, you need to pay close attention when a stock gets bid up to an excessively high P/E level. In the heat of a bull market, it's not uncommon to find "hot" stocks trading at a P/E of 50 or more. While this can go on for some time, eventually the stock's price may drop.
Is a 5 PE ratio good or bad? ›
It is arguable that a PE of five or less is not a remarkable bargain. While it might look as if the company's prospects are being viewed too negatively, it is not a bad rule of thumb to filter out companies with a PE below this level.
Is 70 a good PE ratio? ›
This is because you cannot compare P/E Ratios as absolute values since every industry has a different benchmark. For example, in the FMCG industry, the normal P/E Ratio is around 40-50. Let's look at two FMCG companies: Hindustan Unilever Ltd (HUL) has a P/E ratio of >70.
