What it means
Every share is a claim on a stream of future profits. The P/E ratio prices that claim relative to the current year's profit.
A high P/E means investors expect earnings to grow, or regard them as unusually safe, or both; they are willing to pay many years of today's profit because they believe tomorrow's will be larger. A low P/E means investors expect stagnation or decline, see high risk, or have overlooked the stock.
Neither is inherently good or bad: a P/E of 30 for a company growing at 25% a year may be cheaper than a P/E of 10 for one whose earnings are shrinking. Two versions are common.
Trailing P/E uses the last twelve months of reported earnings and is factual but backward-looking. Forward P/E uses analysts' forecasts for the next twelve months and is more relevant but depends on the forecasts being right.
Both can be distorted by one-off items in earnings, so analysts often use adjusted or normalised earnings, and for cyclical companies a multi-year average (the cyclically adjusted P/E) to avoid buying at peak earnings when the ratio looks deceptively low. The P/E is the inverse of the earnings yield: a P/E of 20 is an earnings yield of 5%, which can be compared with bond yields to judge whether equities are cheap relative to fixed income.
It also links to growth through the PEG ratio (P/E divided by expected earnings growth), which attempts to compare companies growing at different rates. The ratio breaks down in several situations.
It is meaningless for loss-making companies, where earnings are negative. It is misleading when earnings are temporarily depressed or inflated.
It ignores debt: two companies with the same P/E and very different borrowings are not equally valued, which is why enterprise value multiples exist. And it says nothing about the quality of earnings, which cash flow measures address.
It remains the first number most investors look at, and the last one they should rely on alone.
In practice
Real-world examples.
Example
A stock market index trades at a P/E of 18, above its long-run average of 15, prompting commentary that equities are expensively valued.
Example
A bank trades at a P/E of 7 because investors fear loan losses will cut future earnings well below the current level.
Example
A cloud software company trades at a P/E of 60 because investors expect earnings to triple over five years as its subscriber base matures.
Think of it
“P/E shows how expensive a stock is relative to profits-valuation multiple.
Formula
Calculation
P/E Ratio = Share Price / Earnings Per Share = Market Capitalization / Net Profit
Earnings Yield = Earnings Per Share / Share Price = 1 / P/E
PEG Ratio = P/E Ratio / Expected annual earnings growth rate (in percentage points)
Worked example. A consumer goods company's shares trade at $48. Last year's diluted earnings per share were $2.40, and analysts forecast $2.70 for the coming year. Earnings are expected to grow at 12% a year over the next five years.
- Trailing P/E = $48 / $2.40 = 20.0
- Forward P/E = $48 / $2.70 = 17.8
- Earnings yield = $2.40 / $48 = 5.0%
- PEG ratio = 20.0 / 12 = 1.67
Comparison. A competitor trades at $30 with trailing EPS of $2.50 and expected growth of 4%: trailing P/E 12.0, PEG 3.0. On P/E alone the competitor is cheaper; on PEG, the first company's growth makes it the better value. A 10-year government bond yields 4%, so both stocks offer earnings yields above the bond, with the first company's 5% compensating for equity risk only modestly.
Implied expectations: if the first company's earnings grow at 12% for five years, EPS reaches $2.40 x 1.12 to the power 5 = $4.23. If the P/E then falls to 15 as growth matures, the share would be worth $63.45, an annual return of about 5.7% plus dividends. If growth disappoints and EPS reaches only $3.00 at a P/E of 12, the share would be worth $36, a loss. The P/E of 20 embeds a specific bet on growth.Case study
Seen in the real world.
An investor built a portfolio of the ten lowest-P/E stocks in a mid-cap index, reasoning that cheap stocks outperform. Seven of the ten were in cyclical industries (steel, shipping, homebuilding) whose earnings were at a cyclical peak; their low P/Es reflected the market's expectation that earnings would halve. Over the following two years, earnings fell as expected, the P/Es rose to 20 or more without the share prices moving, and three of the companies cut their dividends.
The portfolio underperformed the index by 18 points. The investor's post-mortem introduced two rules: compare the P/E with a ten-year average of earnings rather than a single year, and never buy on a low P/E without a view on why the market has assigned it. The two remaining low-P/E stocks in stable industries, which the investor kept, outperformed.
Watch out
Common mistakes.
- Treating a low P/E as automatically cheap. It often means the market expects earnings to fall.
- Comparing P/Es across industries with different growth and risk. A utility and a software company should not have the same P/E.
- Using a P/E based on a single year's distorted earnings, particularly at cyclical peaks or troughs.
Questions
People also ask.
What is a good P/E ratio?
There is no universal figure. Broad markets have averaged around 15 to 18 over long periods; growth stocks trade higher, cyclical and troubled stocks lower.
What is the difference between trailing and forward P/E?
Trailing uses the last twelve months of actual earnings. Forward uses forecast earnings for the next twelve months.
Why do companies with no earnings not have a P/E?
Because dividing by zero or a negative number gives no meaningful result. Loss-making companies are valued on revenue multiples, cash flow or future earnings instead.
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