The price-to-earnings ratio, or “P/E” for short, is something that helps compare the market price of a company’s stock to the earnings that it generates. P/E ratio helps you to understand if a stock is being undervalued or overvalued by the market.
The P/E ratio is a helpful tool to compare the valuations of a company’s individual stock or an entire stock index (S&P 500 for example), as both can have this calculated. At this time, the P/E ratio for S&P 500 is currently at 34.95. The P/E is constantly fluctuating, as does the price of stocks and indexes, since the market is in perpetual movement.
What Is The P/E Ratio?
The market price of the stock tells you how much people are willing to pay in order to own shares. Whereas, the P/E ratio tells you if that price accurately depicts the company’s value or earning potential over time.
In simple terms, it is the amount of money that someone is willing to pay to earn one dollar. A ratio of 20 means that investors are willing to pay $20 for $1 of earnings a year. To put it another way, if a company has a ratio of 20, it would take that many years to accumulate earnings that are equivalent to the cost of that investment.
How To Calculate Price To Earnings Ratio
The price-to-earnings ratio can be calculated with a rather simple formula. We need to have a basic idea of what each of the components are in order to understand what this number represents:
Price To Earnings Ratio Variables
The “P” within the formula represents the market price per share. The “E” represents the earnings per share. “E”, also referred to as EPS, represents the total profit after tax per total number of shares — which is a formula itself.
Price To Earnings Ratio Formula
Using the variables mentioned above, we can see that the following formula will show us the price-to-earnings ratio:
Using this formula for a simple example, we can calculate what this theoretical company’s price-to-earning ratio is. Let’s assume a company has the following:
- Profit after tax = $500,000
- Number of shares for that company = 100,000
- Market price per share = $100
The first thing we need to do is determine the earnings per share. This can be done by taking the profit after tax and dividing it by the number of shares for the company. After this is done and we have the “E” or “EPS” number. We take the stock price “P” or “market price per share” and divide it by “E” to derive the P/E ratio. For this company it has a P/E ratio of 20 as seen below:
What Is A Good Price To Earnings Ratio?
A price-to-earnings ratio is a swift way to evaluate if stock is undervalued or overvalued. In general, the lower the P/E ratio is, the better it is for the company and its investors. It may be tough to pinpoint an exact value where a P/E ratio may be labeled as good.
There are many other factors that play into comparing success or health of a company. We can say that on average, the S&P 500 has had a P/E ratio somewhere between 13 to 15 historically. So an average company on the S&P 500 with a P/E in that range of 13-15 trades at 13-15 times its earnings.
Types Of P/E Ratio
There are two types of P/E ratios, one that is based on actual data, and the other based on future projections.
Trailing price-to-earnings ratio, is also known as TTM (trailing twelve months). It is a valuation method based on the previous 12 months of actual earnings for a company. The P/E ratio is calculated by using historical data of the company. By using the current stock price and dividing it by the trailing earnings per share over that prior 12 month period. It will be more authentic than forward P/E which happens to use projections.
Forward price-to-earnings ratio, is also known as Forward P/E. This is a valuation method that uses the forecasted earnings of the company over the next 12 months for calculating the price-to-earnings. With this method, finance experts use research reports, analyze the market, make industry assumptions and come up with an earnings average to use as a projection for the next 12 months.
Interpreting Market P/E Ratio
As a general rule of thumb, a low P/E ratio typically indicates that a company has a lower price of stock. A high P/E ratio typically indicates that the company has a higher price of stock.
Interpreting Low P/E Ratio
If a company’s P/E ratio is low, you are paying less to earn that same dollar. This may seem great for investing, but doesn’t tell the story entirely. Companies with a low ratio tend to have less room for growth in general. A low P/E may indicate lower investor confidence. Also, a company could have a low ratio because of bad news surrounding the company.
Interpreting High P/E Ratio
If the P/E ratio is high, it means that you are paying more to earn one dollar. It is important to note that companies with high ratios tend to have more room for growth in the future. A higher ratio could mean that a company is so amazing, investors have such high confidence, that people are buying it regardless.
Consider Guidance From A Financial Advisor
As discussed above, a P/E ratio can be a good indicator of a company’s stock valuation. It is not the only factor that should contribute to your investment decision making though. A lower ratio may seem like a good bet to make money. This could lack the super growth potential of a company that other investors have high confidence in that has a high price-to-earning ratio. Every investor is different and should make their own decisions. People may have questions about how P/E impacts investments or returns. If you want to learn more about it in general, the best bet would be to contact a financial advisor.