Anyone who spends time thinking about investments has likely come across the term price-to-earnings ratio (P/E ratio). This metric reflects the relationship between a company’s stock price and its earnings per share over a 12-month period, offering a gauge of how the market perceives its value. Also known as “price-earnings ratio” or “price per earnings” ratio, it’s a useful tool for evaluating stocks, but it shouldn’t be the sole factor in making investment decisions. However, its simplicity makes it an accessible way to gauge whether a stock is potentially overvalued or undervalued without requiring deep analysis of financial statements.
A financial advisor can help you create a financial plan for your investment needs and goals. Connect with your advisor matches today.
What Is Price-to-Earnings Ratio?
The price-earnings ratio shows the relationship between the price of one share of a stock and the earnings-per-share the company reports over a period of time, generally one year. It shows how much money each investor is putting into the company for every dollar of earnings the company posts.
The formula for calculating the price-earnings ratio is as follows:
Price-earnings ratio = Share price/earnings per share
For example, let’s say that Company A has a share price of $150, and posted earnings-per-share of $25 for the past calendar year. You would calculate the P/E ratio as follows:
- Price-earnings ratio = $150/$25
- Price-earnings ratio = 6
This means investors are paying $6 for every $1 of earnings the company generates. A company that’s losing money has an undefined price-earnings ratio. You can express a negative price-earnings ratio, though.
What Is a Good Price-Earnings Ratio?
There is no universal benchmark for a “good” price-earnings ratio, as the ideal range depends on the industry, economic conditions and the company’s growth prospects. A lower P/E ratio may indicate that a stock is undervalued, potentially signaling an opportunity for value investors. Conversely, a high P/E ratio suggests that investors expect strong future earnings growth, which is common in rapidly expanding industries like technology or biotech.
Sector norms play a crucial role in evaluating P/E ratios. For example, utility stocks typically have lower P/E ratios due to stable earnings and slower growth, whereas tech companies often trade at higher multiples based on projected innovation and expansion.
Investors should also consider whether they are analyzing a trailing P/E ratio, based on past earnings, or a forward P/E ratio, which incorporates future earnings projections.
How to Use Price-Earnings Ratio
Once you know how to calculate the P/E ratio, you can use it to evaluate different companies and decide how you want to invest your money. When it comes to what makes a “good” P/E ratio, there’s generally no hard-and-fast answer to the question. However, different P/E ratios can tell you different things about an investment opportunity.
A high P/E ratio, for instance, means that investors think there will be higher earnings growth in the future. A low P/E ratio might mean that the company is undervalued, making this a valuable tool for value investors. Value investing is an investing strategy that seeks to buy undervalued stocks. Investors who adhere to value investing often look for companies with low P/E ratios as potential investment targets.
When you use the previous year’s earnings, as described above, that’s called the trailing price-earnings ratio. It’s descriptive of what has already happened.
You can also look at analysts’ expectations of what the earnings-per-share will be for a stock in the coming year. This is called the forward or projected price-earnings ratio. While you never know if the company will fare as well as analysts expect, this number can still be useful. It still provides an estimate of expected earnings for each dollar invested in the coming year.
Limitations and Other Considerations
While the price-earnings ratio is a useful metric for investors, it does have some limitations.
For instance, many investors compare the price-earnings ratios of different companies to figure out which one they want to invest in. However, it can be problematic to try to compare investments across different sectors. For instance, if one company is in the tech sector and the other is in the financial services sector, the investments are subject to different market conditions that impact things like valuation and growth rate.
How Macroeconomic Factors Impact P/E Ratio
Certain industry groups also tend to perform well during specific phases of the business cycle. The P/E ratio reflects future earnings expectations. As economies mature, inflation usually increases. This prompts the Federal Reserve to raise interest rates to slow economic growth and control inflation, preventing excessive price increases.
In this type of environment, some industries thrive. For example, banks benefit from rising interest rates, as they can charge more for loans, credit cards and mortgages. Similarly, basic materials and energy companies often see earnings growth during inflationary periods because they can raise prices on the commodities they produce.
On the other hand, during the latter stages of an economic recession, interest rates are typically lower, which can reduce bank profits. However, consumer cyclical stocks may see a boost in earnings, as lower interest rates encourage consumers to make credit purchases.
As such, it’s generally advisable to use the price-earnings ratio as a comparison tool only within one sector. Cross-sector comparisons simply have too many variables to account for.
How Debt Impacts P/E Ratio
Another shortcoming is that the price-earnings ratio doesn’t take into account debt, which can lower share price and earnings. Make sure to look into whether a company has a particularly high debt load. Consider whether a company has a high debt load and how it may be affecting the stock price, earnings or both.
Bottom Line
Price-earnings ratio describes the ratio of the cost of a company’s stock to the earnings per share it posts over a one-year period. It reveals how much shareholders earn from each dollar they invest. Thus, it’s a useful way to determine how much value the money you invest is creating. Stick to comparisons within the same sector when evaluating the price-earnings ratios of different stocks. Otherwise, there will simply be too many variables for the comparison to be worthwhile.
Investing Tips
- If all of this makes your head hurt, consider enlisting the help of a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- After you’re matched, you’ll then get a chance to talk to each of your financial advisor matches. These are the questions you should ask to determine which advisor you want to work with.
- Before you even consider what investments to make, you’ll need to figure out how you want to allocate your assets between different types of securities. SmartAsset’s asset allocation calculator can help you figure that out based on your risk tolerance. If you get a financial advisor, he or she can help you with this as well.
Photo credit: ©iStock.com/cnythzl