Anyone who spends time thinking about investments has likely heard the phrase price-earnings ratio. Put simply, price-earnings ratio, or P/E ratio, is a figure that compares the price of a share of a company’s stock to the earnings per share it posts over a 12-month period.
The price-earnings ratio is a useful tool for evaluating stocks, and investors can use it to determine whether they want to make an investment in a company. Though it isn’t the only metric that investors should use, price-earnings ratio is a fairly simple calculation that provides a lot of information about a stock without needing to dig too deep into complicated numbers and stock information.
What Is Price-Earnings Ratio?
Price-earnings ratio is a figure that 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.
Here is the formula for calculating price-earnings ratio:
Price-earnings ratio = Share price/earning per share
So, for instance, let’s say that Company A has a share price of $150 and posted earnings-per-share of $25 for the past calendar year. Calculate the price-earnings ratio as follows:
Price-earnings ratio = $150/$25
Price-earnings ratio = 6
This means that for every $1 an investor puts into the company, it is generating $6 worth of earnings.
A company that’s losing money has an undefined price-earnings ratio. You can express a negative price-earnings ratio, though.
How to Use Price-Earnings Ratio
Once you know how to figure out price-earnings ratio, you can use it as a way to evaluate different companies and decide how you want to invest your money. There is generally no hard-and-fast answer to the question of what is a good price-earnings ratio. However, different price-earnings ratios can indicate different things about an investment opportunity.
A high price-earnings ratio, for instance, means that investors think there is going to be higher earnings growth in the future. A low price-earnings ratio might mean that the company is undervalued. Investors who use the strategy of value investing might look for companies with low price-earnings ratios as potential investment targets. Value investing is an investing strategy that seeks to buy undervalued stocks, so this an especially useful tool for those investors.
When you use the previous year’s earnings, as described above, that is called the trailing price-earnings ratio. It is 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 analysts expect, this number can still be useful as it foreshadows what to expect in the coming year in terms of earnings for each dollar you invest.
Limitations of Price-Earnings Ratio
While price-earnings ratio is certainly a useful metric for investors, there are problems that can arise when using it.
For instance, many investors compare the price-earnings ratios of different companies to figure out which one they want to invest in. That’s understandable, but problems can come up when you are trying 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. As such, it is generally advisable to use price-earnings ratio as a comparison tool only within one sector. Cross-sector comparisons simply have too many variables to make for an effective tool.
Another shortcoming is that 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. See if that is impacting one or both of the two figures used to calculate price-earnings ratio.
The 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. Make sure, though, to stay within one sector when you are comparing the price-earnings ratios of two different stocks. Otherwise, there will simply be too many variables for the comparison to be worthwhile.
- If all of this makes your head hurt, consider enlisting the help of a financial advisor. SmartAsset makes it easier to find a financial advisor who meets your needs with our free financial advisor matching service. You answer a few questions and we find up to three matches in your area. We fully vet all our advisors and they are free of disclosures.
- 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