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How To Use P/E Ratio To Value a Stock

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When you buy stock, you’re essentially buying a tiny piece of the company it represents. Understanding how profitable the company is in relation to its stock price can be an important consideration for investors.

The definition of the price-to-earnings ratio, usually called a P/E ratio, is the ratio between the price of the company’s stock and the company’s earnings per share. Investors can use P/E ratios to find affordable stocks.

Price-Earnings Ratio

The P/E ratio is a metric used for comparison, so a particular company’s P/E ratio doesn’t tell you much unless you compare it to its historical ratios or the ratios of competing companies. And even then, it doesn’t tell you what the stock is worth, per se. Rather, it suggests what the market thinks the stock is worth.

When you look at a company’s stock valuation statistics on a financial site such as Yahoo Finance, you’ll typically see two P/E ratios listed: forward and trailing.

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Forward P/E Ratio

The forward P/E ratio is based on estimates of future earnings for the coming 12 months. Knowing the forward P/E ratio is helpful to investors because it tells you what kind of earnings the company expects over the next year.

However, companies may change their earnings estimates quarter by quarter, so a given forward P/E ratio may not be accurate.

Trailing P/E Ratio

The trailing P/E ratio, on the other hand, is based on actual earnings over the last 12 months. Because the calculation uses historical earnings performance, the trailing P/E — when compared to the ratios of similar companies and the stock’s own ratio over time — can paint a more accurate picture of a company’s current valuation.

How To Calculate P/E Ratio

You find a trailing P/E ratio by dividing a stock’s share price by the earnings per share, or EPS, which is simply the total net profits from the last year divided by the total number of outstanding shares.

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Share prices change moment by moment, and companies release new earnings figures every three months. As a result, a company’s trailing P/E ratio will change constantly.

Trailing P/E Ratio Example

If a company has a share price of $20 and an EPS of $0.50, that would give it a P/E ratio of 40, meaning the stock is trading at 40 times its earnings per share.

Looking at it simply, the number in a P/E ratio tells you how much you have to pay to get one dollar of underlying company profits. If a company has a share price of $20 and an EPS of $0.50, you need to spend $40 to get the equivalent of one dollar of earnings — two shares.

Forward P/E Ratio Calculation

Analysts calculate a forward P/E ratio by dividing the stock’s share price by estimated future earnings.

What Is a Good P/E Ratio?

A P/E ratio above zero means a company is profitable. Generally speaking, P/E ratios below 15 are considered low, and ratios above 50 are considered high. But is a high P/E ratio good? A lower P/E ratio is typically better because it means you’re getting more bang for your buck, but there are many different factors to consider besides the ratio itself.

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How To Tell If a P/E Ratio Is Good

Different industries have different standards for what constitutes a good P/E ratio, and the size or age of a company can also play a major role in how the market will view a company’s ratio of price to earnings. If you’re trying to decide between buying stock in a massive, established investment bank and a plucky young biotech firm, just comparing their P/E ratios won’t be very useful.

Comparing a company to other similarly sized companies in the same type of business is the best way to judge what a “good” price-to-earnings ratio is. If a stock has a lower P/E ratio than its peers, whether it’s 5, 30 or 50 or more, that’s generally a good sign.

How To Use P/E Ratios When Picking Stocks

Price-to-earnings ratios are one of the most valuable metrics when picking stocks, and investors can follow the practice of “value investing.” This means that you should invest in stocks with low P/E ratios, where you’re getting good value for your investment dollar. Warren Buffett is one of the most notable value investors.

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P/E ratios can also paint an incomplete picture, however. Some companies might have high P/E ratios because they’re reinvesting all of their profits internally to become bigger, better companies. They might look expensive based solely on their earnings ratios, but if their lack of profits means they’re growing rapidly, they’re probably still going to be a strong investment in the long run.

A company with a low P/E ratio could be an old company with an outdated business model that’s on the decline. Investors commonly refer to this as a “value trap.” The company may still be profitable, but its prospects for the future are bleak, meaning it wouldn’t be a smart stock to buy.

A company that has taken on lots of debt to fund expansion will likely have a better P/E ratio than its peers, as the money it is borrowing doesn’t reduce earnings. This company might be a much weaker stock overall because of its larger debt load.

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Do Your Homework

You should always consider a stock’s P/E ratio before investing, but remember that the number is just one piece of a much bigger puzzle. Any purchase of stock should involve carefully researching the company. Be sure that, in addition to knowing its P/E ratio, you also understand what the number means in the context of the underlying business.

FAQ

Although the basic idea behind P/E ratios can be simple to understand, using them to make investment decisions can be tricky. Here are the answers to some of the most frequently asked questions regarding P/E ratios.
  • Is a high P/E ratio good?
    • Generally speaking, a high P/E ratio indicates that a stock is expensive compared to similar stocks with lower P/E ratios. That doesn't necessarily mean it's a bad investment, however. It's important to look at P/E ratios in the context of other factors that make a company worth investing in.
  • Is a P/E ratio of 5 good?
    • A P/E ratio of 5 is considered low. It could be good if similar companies have higher ratios and investors believe the share price is likely to increase.
  • Is a P/E ratio of 30 good?
    • P/Es below 15 are considered low and P/Es above 50 are considered high, so on its face, a P/E of 30 is comparatively neutral. You can determine whether it's good by looking at the company's P/E ratios over time, and comparing the current ratio to the ratios of similar companies. It's also a good idea to research the company's financial performance to get a sense of whether it's likely to grow.
    • Is it better to have a higher or lower P/E ratio?
      • It's usually better to have a lower P/E ratio, which can indicate that a stock is selling at a value price. But there are exceptions. A healthy company with a fortune in cash on its balance sheet might have a high P/E ratio simply because it buys back stock, which returns cash to investors but reduces the number of outstanding shares, skewing the calculation. Investors might be willing to pay a premium for those shares based on the company's strength and growth potential. A company with a low P/E ratio and no other outstanding qualities might be a bad investment if investors perceive a lack of growth potential.
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    Daria Uhlig contributed to the reporting for this article.