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Price-to-earnings (P/E) ratio: Definition, formula, and examples
Price-to-earnings, also known as earnings multiple or price multiple, is a popular metric in the financial world, but what does it actually tell you?
The price-to-earnings ratio or P/E ratio is a company’s current share price relative to its earnings.
Investors can use forward or trailing price-to-earnings, depending on whether they would like to know about performance or forecasted growth.
Historically, the S&P 500’s average P/E ratio has ranged around 20-25, with lower being preferred, but you should look into what is typical for that industry.
You should use P/E ratios in combination with other market analysis tools.
As a new investor, study this valuable tool as part of learning how to trade. Price-to-earnings will become an important part of your trading strategy because it is a metric that you can use to decide whether a share price is over- or undervalued.
Here, we explore the P/E ratio in depth with a definition, formula and practical tips and examples of how to incorporate price-to-earnings into your trading style.
What is price-to-earnings? Definition and formula
The P/E ratio tells you how much investors pay for stock relative to its earnings. The P/E ratio shows how much investors are willing to pay for $1 of a company’s earnings.
The P/E ratio calculation formula is simple:
P/E Ratio = Stock price ÷ Earnings-per-share (EPS)
For example, if a company’s stock is trading at USD 100 per share and its EPS is USD 4, then the price-earnings ratio would be 25. This means that investors are paying USD 25 for every $1 of annual earnings.
Trailing P/E ratios vs. forward P/E ratios
Diving a little deeper, you’ll see that there are two different types of price-earnings ratio: forward and trailing. Investors and market analysts use both. The difference between the two comes from the earnings-per-share figure you choose to use.
Trailing price-to-earnings are retrospective because investors use actual earnings from the past 12 months in their calculations. You can find the right EPS figure to use for trailing P/E ratio calculations by looking out for ttm, with ttm representing ‘trailing twelve months’.
Forward price-to-earnings ratios are speculative because you would use analysts’ forecasts to calculate these. To calculate forward P/E ratios, you’ll need earnings estimates, often found in analyst forecasts or company guidance.
Which is most useful?
Both forward and trailing P/E ratios are useful. If you are looking for stock with a proven history of solid performance, then you need to look at trailing P/E ratios. If you are more interested in fast growth, forward price-to-earnings will be more useful.
What is a typical price-to-earnings and what is good?
Price-to-earnings tend to be around 20 to 25 with a lower ratio preferred. As a general rule of thumb, lower than 20 could represent a good price-to-earnings ratio with over 25 being less desirable.
However, a typical P/E ratio can vary from industry to industry. For example, chemical, insurance and banking are examples of industries with P/E ratios averaging around 10 to 15. Tech, real estate and entertainment industries generally have much higher average price-to-earnings, often around 35 or higher.
Why the variation? P/E ratios vary from industry-to-industry because of unique characteristics. Fast-moving industries like tech tend to have a higher typical P/E ratio whereas highly-regulated industries like banking tend to be lower. Economic trends affect industries in different ways, too, which then affect their average P/E ratio.
How can investors use price-to-earnings?
The fundamental reason to use a price-to-earnings ratio is to answer the question, ‘Is this share price a good deal?’. To answer this question, however, you need to do three things after calculating the P/E ratio.
First, research a typical P/E ratio for the company’s industry. Then, compare the company’s stock price-to-earnings directly with competitors. A higher-than-average price-to-earnings ratio could mean overvalued shares, whereas a lower-than-average P/E ratio could represent a good deal.
Finally, use further analytical techniques to assess this opportunity, such as cross market analysis and chart patterns. Having access to a range of trading skills will mean that you can spot good opportunities and buy, sell or hold financial assets with confidence.
Practical example of how to use price-to-earnings
Let’s say you are interested in buying shares in Netflix. The current price is around USD 1,2oo. Netflix’s most recent ES value is just under USD 23. Using the P/E ratio formula above, the price-to-earnings value is approximately 52.
Clearly, USD 52 is much higher than a typical P/E ratio. However, Netflix’s price-to-earnings has peaked at around 400 on more than one occasion. Looking at some examples, Apple’s current P/E ratio is around 32, and Amazon’s is around 36, which are more typical for the entertainment industry at present.
On face value, Netflix’s current share price probably doesn’t represent a good deal. However, further research using other market analysis tools would help you reach a more informed conclusion.
How to learn more about earnings reports and other market analysis tools
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