Aug 12 · 3 min read
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The price-to-earnings ratio is one of the most popular metrics in investing. More commonly referred to as just the P/E ratio, it is primarily used to help determine whether a stock is under or overvalued. The P/E ratio helps show this value by comparing a stock’s price to its earnings. Hence the “P” & “E”. This comparison shows an investor what they are really paying for when they buy a stock. We will show you the in’s & out’s of calculating a P/E ratio, but don’t worry about calculating this ratio yourself as it is usually shown in the summary statistics of a stock’s profile.
Calculating the P/E ratio of a stock is fairly simple, you take the current price of the stock and divide by the stock's earnings per share (EPS). For example, if a stock’s price is $100 and its earnings per share is $10, the P/E ratio of that stock would be 10. This means investors are willing to pay $10 in share price for every $1 of earnings. Often you will hear this phrased as an investor paying 10 times (10x) earnings to own the stock. This is also why P/E ratios are also known as “price multiples” or “earnings multiples”.
Although this calculation is simple, you have to watch out for small variations in P/E ratios. P/E ratios can vary depending on what type of EPS is used in the calculation. There are a variety of ways you can calculate EPS but the most common are Forward and Trailing Twelve Months (TTM).
A Forward EPS uses an estimation of future earnings while a Trailing Twelve Months (TTM) EPS uses a company’s actual earnings from the past 12 months. When using a Forward EPS in the P/E ratio formula, you will calculate a Forward P/E ratio. When using a Trailing Twelve Months EPS in the P/E ratio formula, you will calculate a Trailing P/E ratio.
To keep things simple, a Forward P/E ratio is primarily used to estimate the future value of a stock. Contrarily, the Trailing P/E ratio uses a company’s last twelve months of earnings to estimate its value. While both P/E ratios are used, you will notice that most stock trading apps and professional investors favor Trailing P/E ratios. This is because Trailing P/E ratios use real earnings, not estimates that can easily be over or understated by the companies themselves.
So you may be wondering, “how do I know what’s a good or bad P/E ratio?”. Unfortunately, there is no specific value that makes a P/E ratio good or bad. The best way to analyze a stock’s P/E ratio is to compare it to similar companies in the same industry, well-known benchmarks like the S&P 500 index, or it’s own historical P/E ratios.
If a stock’s P/E ratio is greater than its peers, the S&P 500’s, or it’s past P/E ratios, it could possibly be overvalued. It could also mean that investors are just expecting a large amount of growth from the company in comparison to its peers. Conversely, if a stock’s P/E ratio is lower than its peers, the S&P 500’s, or it’s past P/E ratios, it could possibly be undervalued or investors are just expecting smaller growth from the company in comparison to its peers. When a company has no earnings or is losing money, it will have no P/E ratio at all.
Ultimately, like all other metrics in stocks, the P/E Ratio alone should not be a single deciding factor of whether to buy or sell a stock. In order to make this decision, you should use P/E ratios as one of the many factors in your analysis.
Stocks: The Basics