Valuation
The P/E Ratio Explained: What It Tells You and What It Hides
The P/E ratio is the most quoted number in investing. It answers one simple question: how many dollars are investors paying for each dollar of annual profit?
The formula
P/E ratio = share price ÷ earnings per share
A stock trades at $80. Over the past 12 months, the company earned $4.00 per share. P/E = 80 ÷ 4 = 20. Investors are paying $20 for every $1 of annual profit.
Trailing versus forward
- Trailing P/E uses actual reported earnings for the last 12 months. It's factual but backward-looking.
- Forward P/E uses analysts' estimates of future earnings. It's forward-looking but only as good as the forecast.
When a website shows a P/E, check which one it is, and whether it uses GAAP or adjusted earnings. The same stock can show very different numbers depending on the choice.
Earnings yield: P/E flipped over
Earnings yield = EPS ÷ price = 1 ÷ P/E
A P/E of 20 is an earnings yield of 5%. Flipping the ratio makes it easy to compare with interest rates: if Treasury bills pay 4%, a stock with a 5% earnings yield offers only a small premium for taking on much more risk. This is one reason stock valuations tend to fall when interest rates rise; see Interest rates and stocks.
Why P/E ratios differ so much
A fast-growing company often trades at a high P/E because investors expect earnings to be much larger in a few years. A slow-growing or risky business usually trades at a low P/E. Neither is automatically right or wrong.
PEG ratio = P/E ÷ expected annual EPS growth (%)
The PEG ratio adjusts for growth. A P/E of 30 with 30% expected growth gives a PEG of 1.0; a P/E of 15 with 5% growth gives a PEG of 3.0. By this measure, the "expensive" stock may be the cheaper one, if the growth actually happens.
Why a low P/E isn't always cheap
A low P/E can mean the market expects earnings to fall. If a company earned $5 a share last year but is about to earn $2, a P/E of 8 on last year's earnings becomes 20 on next year's. Common causes of misleadingly low P/Es:
- Peak earnings in a cyclical industry (steel, autos, homebuilders) just before a downturn.
- One-time gains, such as an asset sale, inflating last year's profit.
- A shrinking business whose earnings are in long-term decline.
Investors call these value traps: stocks that look cheap and stay cheap, or get cheaper.
Other ratios worth knowing
| Ratio | Formula | Useful when |
|---|---|---|
| Price-to-sales | Market cap ÷ revenue | Earnings are negative or unusually depressed |
| Price-to-book | Price ÷ book value per share | Banks, insurers and asset-heavy businesses |
| EV/EBITDA | Enterprise value ÷ earnings before interest, taxes, depreciation and amortization | Comparing companies with different amounts of debt |
| Free-cash-flow yield | Free cash flow per share ÷ price | Checking whether earnings turn into cash |
How to use P/E sensibly
- Compare a company's P/E with its own 5- to 10-year range.
- Compare it with direct competitors, not the whole market.
- Ask what growth the P/E implies, and whether that growth is believable.
- Check the earnings behind it: GAAP or adjusted? Recurring or one-time?
Price-to-earnings, earnings yield, and a two-stage discounted cash flow estimate. Free download: Valuation Worksheet
P/E, PEG, free-cash-flow yield and a simple DCF on paper. (PDF)
Common questions
What is a good P/E ratio?
There is no universal good P/E. It depends on the company's growth, risk, industry and interest rates. Compare a company's P/E with its own history, with similar companies and with its expected growth.
What is the difference between trailing and forward P/E?
Trailing P/E uses earnings from the last 12 months. Forward P/E uses analysts' estimates for the next 12 months or the next fiscal year, so it depends on forecasts that may be wrong.
Why does a company with no earnings not have a P/E?
If earnings are zero or negative, the ratio is meaningless. For unprofitable companies, analysts use other measures such as price-to-sales or enterprise value to revenue.