What Is The P/E Ratio Of A Stock, And What Does It Tell About A Company?

A plot by Robert Shiller showing the average P/E ratio among stocks in the S&P 500 index fund, as well as the long-term interest rates, from 1871 to 2012.

On any brokerage app, like Robinhood, you’ve probably seen something called a price-to-earnings ratio, or P/E ratio, listed under a stock’s dashboard. The P/E ratio is one of the most common tools that investors use to evaluate a stock before actually putting money in. As the name suggests, the P/E ratio compares the price of a stock to the earnings of the company that issues it. In simple terms, it shows how much investors are willing to pay for one dollar of the company’s profit, which is also referred to as earnings. To calculate it, you divide the current price of a share by the earnings per share over the last year. Here’s the equation for it, where “p” represents the current price of a share, “e” represents the company’s annual earnings, and “y” represents the number of total shares:

P/E Ratio = p/(e/y)

For example, if a company has made a profit of $50,000,000 over the past year, has issued 10,000,000 shares in total, and has its stock trading at $50 per share, the company’s P/E ratio would be 10. The ratio is used by investors to measure whether a stock is expensive or cheap compared to its earnings. The P/E ratio gives information about market expectations. When the P/E ratio is high, it usually means that investors are expecting strong future growth. In other words, they are willing to pay more now because they believe the company will earn more in the future. A low P/E ratio, on the other hand, can mean that the market has low expectations for the company or that the stock is undervalued. It’s important to note that just because a stock’s P/E ratio is low or high does not necessarily mean that the stock is a bad or good investment. Some industries naturally have higher P/E ratios than others. For example, technology companies are typically seen to have higher P/E ratios than agriculture companies because investors expect faster growth. Similar to agriculture companies, utility companies also often have lower ratios because of their slow and stable growth.

Contrary to popular belief among amateur investors, there is no single ideal P/E ratio. It changes depending on the market, the industry, and the company itself. Some analysts use 15 or 20 as a rough guideline, but again, that number is not a strict rule. However, comparing a company’s P/E to the average in its industry is a much better way of gauging a company’s true worth relative to other similar companies. If a company has a lower P/E ratio than its peers, it’s very likely that it’s either undervalued or has inherent problems. If a company has a higher P/E ratio, it may have stronger growth prospects or investor confidence.

The P/E ratio also gives a hint about risk. Stocks with high P/E ratios are often more volatile. So, if the company does not meet expectations, the stock price will fall quickly as investors cash out. Stocks with low P/E ratios are usually more stable, but the trade-off you have to make is that growth will also be slower. Good investors don’t just look at P/E ratios to come to a decision. They hold it against other measures like debt, revenue growth, and profit margins to get a fuller picture of the company’s situation. No single ratio in investing ever tells the full story!

Within P/E ratios, there are many types. The most common is the trailing P/E ratio, which is what we’ve discussed so far. In its calculation, earnings from the past twelve months are used. Another type is the forward P/E, which uses expected earnings for the next twelve months. The forward P/E depends on estimates and predictions, so it’s less reliable, but it still helps investors look ahead. Some analysts also use adjusted P/E ratios, which remove unusual gains or losses (outliers) to get a clearer view of normal earnings.

The most useful aspect of knowing a company’s P/E ratio is the ability to use it for comparison. For investors, it’s most helpful to compare the P/E ratios of stocks in the same industry or sector. As we stated before, technology companies and agriculture companies have different growth rates and risks, so using P/E ratios to compare them is usually not meaningful. Investors also look at trends over time. If a company’s P/E ratio rises, it may show increasing investor confidence. If it falls, it may indicate growing concern or slower expected growth.

Investors also watch the overall market P/E ratio. The average ratio of all stocks in a market can indicate whether the market is expensive or cheap. High market P/E ratios may mean stocks are overvalued and future returns could be lower. Low market P/E ratios may signal potential opportunities or caution depending on the economy. Analysts compare individual stocks to the market P/E to decide if a stock is worth buying at its current price.

The P/E ratio reflects both price and earnings, so changes in either affect the number. If a company’s stock price rises without a rise in earnings, the P/E ratio increases. If earnings rise faster than the stock price, the ratio falls. This relationship makes the P/E ratio a dynamic measure. Investors need to watch both earnings reports and market movements to understand why the ratio changes.

To conclude, the P/E ratio is a simple but useful tool for evaluating a stock. It shows how much investors pay for each dollar of earnings and gives insight into market expectations and potential risk. There is no ideal P/E that works for all companies, but comparing a stock to its peers or to the overall market provides useful context. Investors use it with other financial measures to make better decisions. The ratio is not perfect, but it offers a quick way to judge whether a stock is likely overvalued, undervalued, or fairly priced based on earnings. So, if you are considering investing in a stock, definitely look at its P/E ratio, but take it with a grain of salt!