As an investor, one of your primary objectives is to determine whether a stock or fund will increase in value over time. While there is no crystal ball to provide you with any certainty, there are various tools you can use to make smarter decisions. One such example is a price-to-earnings (PE) ratio.

What is a PE ratio, and how is it calculated?

A PE ratio (also known as the “price” or “earnings” multiple) is a metric used to value a company’s stock price. More specifically, it can help you determine if a stock’s market price is undervalued, appropriately valued, or overvalued—thereby informing your decision to buy, sell, or keep the stock.

The math behind a PE ratio is simple: just divide the stock price by its earnings per share (EPS). For example, if a stock is trading for $50 per share and that same company (referred to as “ABC” from this point forward) generates $2 per share in annual earnings, the corresponding PE ratio would be 25.

While this individual equation is straightforward, the formulas used to calculate a PE ratio can get very tricky as one can determine the EPS using various methods. While these variants are sometimes helpful, they also have their shortcomings. Let’s explore each one in more detail…

Using a PE ratio to analyze individual stocks:

Trailing PE ratio
The most widely used approach is the trailing (or TTM) ratio, which uses the company’s trailing (or previous) 12 months of earnings to calculate earnings per share. Its popularity stems from its high level of objectivity—the most of any metric, in fact. Many financial websites and investment apps (e.g., Yahoo! Finance, Google Finance, and Robinhood) use the TTM method, but one of its biggest drawbacks is that past performance doesn’t guarantee future results; and investors naturally purchase stocks based on future earnings rather than past events, of course.

Forward PE ratio
Another PE variant preferred by analysts—especially for growing companies—is the “forward” or “expected earnings” method (also known as “estimated price to earnings”). This indicator, an excellent measure of a company’s financial health, uses expected earnings for the coming year to calculate EPS (a number typically found in an earnings release). Keep in mind that expected earnings is a prediction of how the company will perform in the future; using this method to determine an EPS is therefore by no means an exact science. External analysts such as Morningstar provide earnings estimates that sometimes differ from their company counterparts, making the PE ratio even more confusing to investors.

Many investors use both trailing and forward PE ratios to analyze stocks. While these figures sometimes mirror one another, that’s not always the case. In this way, variance can serve as an impetus to dig deeper into corresponding causes.

Using a PE ratio to analyze the entire market:

S&P 500 PE ratio
To calculate this ratio, divide the sum of all stock prices in the index by the total earnings per share (EPS) of S&P 500 companies over the last 12 months or their projected EPS over the next 12 months (known as a “forward PE ratio”). The historical average PE ratio of the S&P 500—approximately 16—is an important benchmark for evaluating the current ratio. If the latter is higher than the historical average, the index is perhaps overvalued (indicating that S&P 500 stock prices are relatively high compared to their earnings). On the other hand, a lower PE ratio may imply the index is undervalued, suggesting that the stocks within the index may be priced relatively lower compared to their earnings. As with other analyses, this ratio has its own fair share of challenges; for example, the ratio remained above average for much of the mid 2010s, but the next major downturn didn’t occur until 2020.

Schiller PE ratio
The Shiller PE ratio (also known as the “CAP/E ratio”) relies on average earnings over a 10-year period for analysis purposes (adjusted for inflation). While investors can use this method to analyze individual stocks, it is generally applied to an entire stock market index—such as the S&P 500. As with other PE ratio metrics, this one also has its drawbacks especially since it examines historical performance figures.

How to use a PE ratio in your own investment strategy

A PE ratio tells you how much a buyer is willing to pay for $1 of a company’s earnings. Using our earlier example, the current number suggests investor willingness to pay $25 for every $1 of ABC’s earnings. However, merely knowing ABC’s PE ratio is useless in the absence of something to compare it to: such as ABC’s historical PE range, peers within the sector, or a benchmark index (e.g., the Dow Jones or S&P 500 index).

Let’s assume ABC and its competitor, XYZ, are peers within the energy sector. Furthermore, imagine ABC has a stock price of $200 and a PE ratio of 25 while XYZ has a stock price of $50 and a PE ratio of 10. In this scenario, you’d pay $25 for every $1 of earnings for ABC stock while paying much less for XYZ stock ($5 for every $1 of earnings).

From there, you’ll need to research PE ratios a little bit more—learning why investors are willing to pay so much more for ABC stock and, by the same token, why XYZ stock is relatively inexpensive. For example, do investors expect higher future earnings for ABC since it’s a growing company? Alternatively, the stock is perhaps overvalued—especially if ABC’s earnings fell but its stock price did not. XYZ’s low PE ratio, meanwhile, could imply the stock is undervalued—especially if company earnings increased but the stock price didn’t follow suit. A low PE ratio could also mean investors are pessimistic about XYZ’s future earnings.

As you’ve probably figured out already, PE ratios offer a good starting point for stock valuation but don’t give you all the answers and information you’ll need to invest in a stock. You can therefore consider them just one tool in your investment toolbox.

What is a “good” PE ratio?

Because PE ratios are used to compare stocks, a single ratio on its own is not easily defined as either “good” or “bad.” Generally speaking, however, many value investors consider a below-average PE ratio preferable whereas an above-average figure is ideal for growth investors.

Other details to know about PE ratios

As some industries grow much faster than other, more mature sectors, investors shouldn’t use PE ratios to compare stocks across industries.

Heavily cyclical industries—with performance often directly tied to the strength of the economy—sometimes have deceptive PE ratios, depending on the economic cycle. For example, if profits are booming, an inflated EPS can make a stock seem cheap. Alternatively, in a recession or slow-growing economy, profits are depressed—making a stock appear expensive. Examples of such industries include homebuilders and commodity producers of resources such as oil and gas.

Moreover, earnings aren’t always so clear-cut. Some companies use creative accounting methods (such as shifting depreciation policies) to meet earnings expectations. Unusual gains or losses can also affect earnings. Therefore, investors should always remain wary of methods used to derive company earnings numbers—which can impact PE ratios.

In sum: the price-to-earnings ratio, explained

It’s important to know that while PE ratios can offer a quick stock valuation, it’s important to evaluate a variety of other metrics (e.g., company fundamentals, industry metrics, and overall economic indicators) before deciding to invest. That’s why—at least for most of us—leaving the decisions to the experts is often the most prudent approach when investing.

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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.