Price to Earnings Ratio (P/E)
Ratios
Overview
The price to earnings ratio is a valuation metric that measures the share price relative to the earnings per share (EPS) of a company. In essence, it shows how much investors are willing to pay for one dollar of earnings.
Alternative Names: PE, PE Ratio, Price Multiple, Earnings Multiple
Formula
Price to Earnings Ratio = Price ÷ Earnings Per Share (EPS)
Where:
- Price: Current stock price per share
- Earnings Per Share (EPS): Company's net earnings divided by total shares outstanding, found on the income statement
Calculation Example
Let's calculate the price to earnings ratio for a hypothetical company to demonstrate the process:
Example Company - Financial Data:
- Current Stock Price: $60.00
- Earnings Per Share (EPS): $3.00
Calculate Price to Earnings Ratio
P/E = $60.00 ÷ $3.00
= 20x
Interpretation: A P/E ratio of 20 means investors are willing to pay $20 for every $1 of earnings by this company. The ratio can also be viewed as 20 years—the number of years of earnings it would take to pay back the purchase price, assuming earnings remain constant.
How to Interpret
The P/E ratio can be viewed as units of years, representing the number of years of earnings needed to pay back the purchase price. For example, if a company has a P/E ratio of 20, that means investors are willing to pay $20 for one dollar of earnings by this company.
General Guidelines:
Low P/E Ratio (Below 15): Potentially Undervalued
Lower P/E ratios may indicate the stock is undervalued relative to its earnings, potentially representing a buying opportunity if fundamentals are strong. However, it could also reflect legitimate concerns about the company's future prospects, declining growth, or industry-specific challenges.
Moderate P/E Ratio (15-25): Fairly Valued
P/E ratios in this range are typical for many mature companies. The valuation aligns with market norms, suggesting balanced expectations for future performance and growth.
High P/E Ratio (Above 25): Growth Expectations
Higher P/E ratios usually indicate increased demand for the stock because investors anticipate earnings growth in the future. Companies with accelerated growth typically have increasing P/E ratios as investors project future growth. However, this carries higher risk if the company fails to meet expectations.
Growth vs. Cyclical Companies: Companies with accelerated growth will typically have increasing P/E ratios as investors project future growth. Cyclical companies will have P/E ratios that vary depending on where in the business cycle the company is at the moment. Always analyze historical P/E trends to understand company-specific patterns.
Why It Matters
The P/E ratio is one of the most commonly used stock valuation tools. It provides critical insights into investor demand, company valuation relative to profitability, and expectations for future growth.
Key Insights:
- Current Investor Demand Indicator: The P/E ratio number shows the current investor demand for a company's shares. Higher ratios indicate greater willingness to pay premium prices for earnings, reflecting confidence in future growth.
- Cross-Company Comparison Tool: The P/E ratio can be used to compare the value of different companies in the market in relationship to their profitability, enabling apples-to-apples comparisons across companies of different sizes within the same industry.
- Historical Valuation Tracking: Analyzing the historic P/E ratio of a stock tells investors how the value of the company has changed over time. This historical perspective helps identify trends, valuation cycles, and whether current prices are reasonable compared to the company's past.
- Growth and Cycle Assessment: Companies with accelerated growth typically have increasing P/E ratios as investors project future growth. Cyclical companies show P/E variation depending on their position in the business cycle, making trend analysis essential.
Key Takeaways
- The P/E ratio measures share price relative to earnings per share, showing how much investors pay for one dollar of earnings
- Calculated by dividing current stock price by earnings per share (EPS)
- Can be interpreted as years—the number of years of earnings needed to pay back the purchase price
- Low P/E (below 15) may indicate undervaluation, moderate P/E (15-25) suggests fair valuation, high P/E (above 25) reflects growth expectations
- High P/E ratios usually indicate increased demand because investors anticipate future earnings growth
- The P/E ratio is one of the most commonly used stock valuation tools for comparing companies
- Historical P/E analysis shows how company valuation has changed over time
- Growth companies typically have increasing P/E ratios, while cyclical companies show P/E variation based on business cycle position
- Always compare P/E ratios within the same industry, as normal ranges vary significantly by sector
- Should be analyzed alongside other valuation metrics like P/B, P/S, and EV/EBITDA for comprehensive evaluation
Related Financial Ratios
These related metrics provide additional insights for comprehensive financial analysis:
Price to Book Ratio (P/B)
Compares market value to book value of equity, useful for valuing asset-heavy companies and identifying stocks trading below their balance sheet value.
Price to Sales Ratio (P/S)
Compares market capitalization to total revenue, particularly useful for evaluating unprofitable or high-growth companies where earnings may be negative or volatile.
EV/EBITDA Ratio
Compares enterprise value to earnings before interest, taxes, depreciation, and amortization, providing a comprehensive valuation that accounts for debt and is useful for M&A analysis.
PEG Ratio
Adjusts the P/E ratio by the company's earnings growth rate, enabling fairer comparison of companies with different growth profiles and identifying growth stocks at reasonable valuations.