The price-to-earnings (P/E) ratio measures a company’s share price relative to its earnings per share (EPS). Often called the price or earnings multiple, the P/E ratio helps assess the relative value of a company’s stock. It’s handy for comparing a company’s valuation against its historical performance, against other firms within its industry, or the overall market. P/E can be estimated on a trailing (backward-looking) or forward (projected) basis.
Key Takeaways
- The price-to-earnings (P/E) ratio is the proportion of a company’s share price to its earnings per share.
- A high P/E ratio could mean that a company’s stock is overvalued or that investors expect high growth rates.
- Companies with no earnings or are losing money don’t have a P/E ratio because there’s nothing to put in the denominator.
- The two most used P/E ratios are forward and trailing P/E.
- P/E ratios are most valuable when comparing similar companies in the same industry or for a single company over time.
P/E Ratio Formula and Calculation
The formula and calculation are as follows:
P/E Ratio = Market value per share / Earnings per share
To determine the P/E value, divide the stock price by the EPS. The stock price (P) can be found simply by searching a stock’s ticker on a reputable financial website. Although this concrete value reflects what investors currently pay for the stock, the EPS is related to earnings reported at different times.
EPS is generally given in two ways: Trailing 12 months (TTM) represents the company’s performance over the past 12 months, while earnings releases often provide EPS guidance for future expectations. These different versions of EPS form the basis of trailing and forward P/E, respectively.
Understanding the P/E Ratio
The P/E ratio is one of the most widely used metrics by investors and analysts reviewing a stock’s relative valuation. It helps determine whether a stock is overvalued or undervalued. A company’s P/E can also be benchmarked against other stocks in the same industry or against the broader market, such as the S&P 500 Index.
Analysts interested in long-term valuation trends can look at the P/E 10 or P/E 30 measures, which average the past 10 or 30 years of earnings. These measures are often used when trying to gauge the overall value of a stock index, such as the S&P 500.
The P/E ratio of the S&P 500 has fluctuated dramatically over time, with important benchmarks like a low of 5.9 in mid-1949 and a high of 122.4 after the 2008 financial crisis. The long-term average for the S&P 500 is about 17.6. This average can be useful as a benchmark to determine if the market is currently over or undervalued compared to historical averages.
When to Review the P/E Ratio
Analysts and investors review a company’s P/E ratio to assess whether the share price accurately represents the projected earnings per share.
Forward Price-to-Earnings
The forward P/E uses future earnings guidance rather than trailing figures. Sometimes called “estimated price to earnings,” this forward-looking metric helps compare current earnings to future earnings and provides a picture of anticipated growth without accounting biases.
However, the forward P/E has its shortcomings. Companies might underestimate earnings to exceed future estimates or external analysts’ estimates may diverge, creating possible confusion.
Trailing Price-to-Earnings
The trailing P/E relies on past performance by dividing the current share price by the total EPS for the previous 12 months. It’s popular due to its reliance on historical data. Yet, it has pitfalls: past performance isn’t necessarily indicative of future earnings, and trailing P/E might not reflect recent significant events affecting stock price or earnings.
Valuation From P/E
The P/E ratio isn’t just a measure of whether a stock’s price is overvalued or undervalued. It also reveals how a stock’s value compares with its industry or a benchmark, like the S&P 500, providing broader context to the numbers.
For example, if a company trades at a P/E multiple of 20x, investors pay $20 for every $1 of current earnings. This valuation can indicate market sentiment towards the company.
Examples of the P/E Ratio
Let’s clarify this with an example, looking at FedEx Corporation (FDX). As of Feb. 9, 2024, the company’s stock price closed at $242.62 with an EPS of $16.85:
P/E Ratio = $242.62 / $16.85 = 14.40
Comparing Companies Using P/E
Let’s look at two energy companies to see their relative values. On Feb. 9, 2024, Hess Corporation (HES) had a stock price of $142.07 and a diluted 12-month trailing EPS of $4.49, resulting in a P/E of 31.64.
Comparatively, Marathon Petroleum Corporation (MPC) had a stock price of $169.97 and a diluted EPS of $23.64, giving it a P/E of 7.19. When you compare HES’s P/E of 31.64 to MPC’s 7.19, HES’s stock could seem overvalued relative to the S&P 500 and MPC. HES’s higher P/E might also mean that investors expect substantially higher earnings growth in the future.
Investor Expectations
Generally, a high P/E signals that investors expect higher earnings growth compared to companies with lower P/Es. It can also indicate the company is undervalued relative to its historic performance. When a company has no earnings or is posting losses, the P/E is expressed as N/A, not commonly calculated.
P/E vs. Earnings Yield
The inverse of the P/E ratio is the earnings yield (EPS/Price). If Stock A is trading at $10 with an EPS of $0.50, it has a P/E of 20 and an earnings yield of 5%. If Stock B is trading at $20 with an EPS of $2, it has a P/E of 10 and an earnings yield of 10%.
P/E vs. PEG Ratio
Though setting aside growth rates can mischaracterize value, the PEG ratio addresses this by comparing the P/E ratio to earnings growth rate. A PEG less than one indicates a possibly undervalued stock, while greater PEG ratios suggest potential overvaluation.
Absolute vs. Relative P/E
Absolute P/E
The numerator commonly sees the stock’s current price, while the denominator involves the trailing or forward EPS.
Relative P/E
The relative P/E compares the absolute P/E to benchmarks or a range of past P/E values, emphasizing where current valuation stands relative to historical figures.
Limitations of Using the P/E Ratio
P/E ratios face limitations when comparing companies from varied sectors or dealing with firms without current earnings. Additionally, manipulation of EPS and share prices means reliance must be tempered by cross-examination with other metrics.
Other Considerations
Leverage and debt can affect share price and earnings, thus impacting the P/E ratio. Trust in accurate earnings representation is fundamental, otherwise potentially skewing analyses.
The Bottom Line
The P/E ratio is a crucial measure for determining stock valuation. While it isn’t singularly definitive, it provides essential context requiring supplementary financial measures for comprehensive evaluation.
Related Terms: earnings yield, PEG ratio, trailing P/E, forward P/E.
References
- Macro Trends. “S&P 500 PE Ratio - 90 Year Historical Chart”.
- Yahoo Finance. “FedEx Corporation (FDX)”.
- Yahoo Finance. “Hess Corporation (HES)”.
- Wall Street Journal. “Markets”.
- Yahoo Finance. “Marathon Petroleum Corporation (MPC)”.
- Charles Schwab. “How To Value Company Stocks: P/E, PEG, and P/B Ratios”.
- State Street Global Advisors SPDR. “Communication Services Select Sector SPDR Fund”.
- State Street Global Advisors SPDR. “The Technology Select Sector Fund”.
