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Price-to-Earnings Ratio


What Is Price-to-Earnings Ratio?

The price to earnings ratio (P/E) is used to value a company by comparing its earnings per share to its stock price. Juxtaposing the current P/E to past P/Es, and P/Es of other companies suggest whether or not a company is fairly valued, overvalued, or undervalued.

The ratio is also used to measure the growth potential of a company. When comparing a set of P/Es, higher P/Es indicate stronger growth expectations; lower P/Es indicate weaker growth expectations.

How is the Price-to-Earnings Ratio Calculated?

The calculation is simply the price of the stock divided by the Earnings per Share (EPS).

P/E = Stock Price/EPS

'Trailing P/E' is the most commonly used version of this metric. It uses the current price and the average earnings per share over the past twelve months. For example, if a stock is trading at $100 per share and the average earnings of the last 12 months are $5 per share, the trailing P/E ratio is 20. Alternatively, if the forecasted 12 months of earnings are used it is called a ‘Forward P/E’.

How to Use a P/E Ratio

Contrasting P/Es of companies in the same sector is one of the most popular ways to compare stocks to one another. For example, if the stock of company ABC is trading at $100 per share, while company XYZ is trading at $50 per share, the assumption might be that ABC is more valuable.

However, if the earnings per share of both are $5, the P/E of the former, ABC, would be 20 while the P/E of the latter, XYZ, would be 10. Thus, XYZ is a better value because, for every investment of $10 in XYZ, $1 is returned each year whereas ABC requires $20 for a yearly return of $1.

If these companies have similar profiles and both are in the same sector, with an average P/E of 13, it would suggest that the P/E of ABC is abnormally high and the company is overvalued. A return to the average P/E of the sector could occur by a fall in price or a rise in earnings.

Comparing a stock’s current P/E to its previous P/Es indicates how performance expectations have changed. A P/E that declines over time is either experiencing an improvement in earnings that are not translating to a higher price, or a fall in prices while earnings remain the same.

If price and the P/E are rising, investors see an improvement in the company’s growth potential despite a lack of improvement in earnings. If the price is falling and the P/E is rising, earnings are also falling at a faster rate, suggesting shrinking growth expectations.

New companies in new industries, with high growth potential and low earnings, often have high P/Es, while established companies in established industries are more likely to have low P/Es due to limited growth potential and higher earnings. The average P/E of companies listed on the small-cap Russell 2000 index in December 2018 was 41.45 while the average P/E of companies listed on the large-cap S&P 500 in December 2018 was 21.33.

Drawbacks to Consider When Using P/E Ratios

A major blind spot of the P/E ratio for comparing companies is that it does not consider other company characteristics, such as debt. For example, company XYZ may have a lower P/E than company ABC, suggesting it is generating more for every dollar invested by stockholders. However, if those revenues have been achieved as a result of heavy borrowing, investors must determine if those strong earnings can be maintained without creating a fatal debt profile.

Also note that earnings per share are reported by companies, not independent third parties, which creates the possibility that data favors the company.

Finding Price-to-Earnings Information on

At the P/E of every stock can be found on the homepage of each company just below the main chart in the center column of the table, e.g. Amazon (NASDAQ:AMZN). It can also be found under the Financials tab by clicking the Ratios link.

On the Ratios page, the P/E row shows the company’s P/E ratio in the first column and the average industry P/E ratio in the second column.

Another useful tool that provides P/E data is the Stock Screener, which can be found under the Tools dropdown on the black bar at the top of every page. This page features a sortable column of P/E ratios, available under the Fundamental tab of the table.

To filter for specific P/E criteria, use the arrows at the top of the P/E Ratio column to sort the information appropriately. An additional way to find the specific information you might be looking for is to use the 'Add Criteria' box above the table. Click on the Popular or Ratio links at the upper left of the page and adjust the parameters you're interested in on the right of the screen.

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