Price-to-Earnings (P/E) Ratio
What is Price-to-Earnings (P/E) Ratio?
The P/E ratio is a stock's price divided by its earnings per share, showing how much investors pay per dollar of earnings.
A high P/E can signal that investors expect strong growth, or that a stock is overvalued; a low P/E can signal a bargain or weak prospects. It is used to compare valuations across companies.
Price-to-Earnings (P/E) Ratio: a worked example
Larkspur Tools reports net income of $84 million on 40 million shares, so earnings per share is $84 million ÷ 40 million = $2.10. The stock trades at $37.80, giving a P/E of $37.80 ÷ $2.10 = 18. Rival Rivet Machinery trades at $12.00 with EPS of $2.00, a P/E of 6. Buyers of Larkspur pay $18 for each dollar of annual earnings; buyers of Rivet pay $6. Flip the ratio to get the earnings yield: 1 ÷ 18 = 5.6% for Larkspur against 1 ÷ 6 = 16.7% for Rivet. The gap prices what buyers expect next, not what either firm already earned.
The mistake students make with price-to-earnings (p/e) ratio
The tempting reading is that a low P/E marks a bargain. The denominator is earnings the company already reported, and those earnings can be about to fall. If Rivet's EPS drops from $2.00 to $1.00, its P/E doubles from 6 to 12 with no move in the share price at all, and the stock that looked cheap was simply pricing in the decline. The mirror error is comparing across industries: capital heavy utilities and fast growing software firms carry different normal ranges.
Price-to-Earnings (P/E) Ratio questions
What is a good P/E ratio?
A good P/E ratio has no universal value, because the number only carries meaning against a comparison. The useful comparisons are the company's own history, direct competitors in the same industry, and the growth rate the price implies. A high ratio is justified when earnings are growing quickly and unjustified when they are flat, so the ratio poses a question worth investigating rather than delivering a verdict.
What does a negative P/E ratio mean?
A negative P/E ratio means the company lost money, so earnings per share is below zero. Dividing a positive share price by negative earnings gives a negative number that cannot be ranked against positive ones, which is why data providers usually display it as not applicable. Analysts covering unprofitable firms switch to other measures, such as price to sales or price to book, until earnings turn positive.
What is the difference between trailing and forward P/E?
Trailing P/E divides the share price by earnings the company has already reported, while forward P/E divides it by the forecast for the coming year. Forward ratios look lower whenever earnings are expected to grow, because the denominator is bigger. Trailing numbers are facts that can be stale; forward numbers are opinions that can be wrong, so setting one company's forward ratio against another's trailing ratio is not a fair comparison.
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