In this article, we'll cover price-to-earnings (P/E) ratio, including the price earnings ratio definition, the P/E ratio calculation, what is a good P/E ratio and "Why is P/E ratio important?"
Many investors enjoy picking stocks. But knowing which stocks to choose can challenge even the most experienced investor, because investor sentiment can move a stock in irrational ways.
You can take the emotion out of your stock selections. One way to do that is to look at fundamental metrics like a stock’s price-to-earnings (P/E) ratio. While not a perfect indicator of a stock’s future performance, it can provide a barometer of how retail and institutional investors feel about a particular stock.
What is a P/E Ratio?
So, what is P/E ratio? The price-to-earnings ratio measures how much you pay for $1 of a company’s earnings. Therefore, when a company has a P/E ratio of 15, its shareholders pay $15 for every dollar of company earnings.
Value investors use a stock’s P/E ratio to determine its valuation. The ratio reveals how a stock’s value compares with the industry average or a benchmark index.
Calculating the P/E Ratio
The two components of the P/E ratio are a company’s stock price and its earnings per share over a period of time (usually 12 months).
Stock price (the "P" in the P/E ratio) tells investors how much it will cost them to buy one share of a company’s stock. Earnings per share (the "E" in the ratio) gives investors an idea of how valuable those shares are.
With that in mind, how is P/E ratio calculated? The formula is:
Stock price/EPS = P/E ratio
How to Analyze P/E Ratio
A stock’s P/E ratio doesn’t tell the whole story. Some investors have other favorite metrics, such as price-to-book ratio or price-to-earnings, including growth (or PEG) ratio. Look at a company’s P/E ratio and other data, such as a company’s debt-to-equity ratio.
Analyzing the significance of a P/E ratio is similar to assigning importance to a batting average in baseball or softball. P/E ratio helps predict future outcomes but cannot help you fully evaluate a stock.
One reason is that the two components of a P/E ratio (stock price and earnings per share) will depend, in part, on what type of company you analyze. A company with fast-growing earnings will command a higher P/E ratio than a company with slow but steady revenues.
You may also want to look at how the P/E ratio of a stock compares to others in its sector. You would expect the market share leader in a sector to have a higher P/E ratio than the fifth- or sixth-highest company by market share.
How is the Trailing P/E Ratio Different than the Forward P/E Ratio?
You use the earnings per share of the last four quarters to calculate the price-to-earnings ratio, a metric normally referred to as trailing earnings per share. The most commonly displayed P/E ratio is a trailing P/E ratio. Trailing P/E is based on the most recent four quarters of earnings. In all but one quarter of the year, the P/E ratio reflects earnings occurring in the current fiscal year and those that the company delivered in the prior fiscal year.
Some investors use a different metric, the forward P/E ratio, which comes from the company’s guidance. It’s common for company management to issue earnings forecasts for subsequent quarters. Investors and analysts can use these numbers to calculate a forward P/E ratio. It gives investors an idea of the company's confidence in the profit forecast over the next four quarters.
For investors looking to take a long position in a company’s stock, the forward P/E ratio may be more valuable than its current P/E ratio. By contrast, short-term traders may care more about current P/E ratios because they want to profit in the short term.
How to Use the P/E Ratio Calculator
The MarketBeat P/E ratio calculator is a tool that investors and traders can use to find the current market value of a stock. MarketBeat publishes a series of calculators, such as the MarketBeat compound interest calculator, the MarketBeat inflation calculator and the MarketBeat market capitalization calculator, creating a one-stop site for investors to research stocks.
The MarketBeat P/E calculator is intuitive, but here are step-by-step instructions:
Step 1: Enter the ticker symbol directly.
If you know the ticker symbol of the stock you’re looking for, enter that into the “Choose a Stock to Populate Sell Price” field. MarketBeat will populate the tool from its search engine to give you the current market P/E ratio for that stock.
Step 2: Enter the share price.
As we noted above, this is the current price at which the stock trades. You don’t need to think about it beyond that. However, note that this price will frequently change during the trading day.
Step 3: Enter the total earnings per share for the measured time period.
If you’re on the MarketBeat site, you can find this by looking at the "Earnings" tab on the profile page for the particular stock you've chosen.
P/E Ratio Calculation Examples
Here are a couple of examples using stock prices and EPS values as of December 16, 2022:
Tesla Inc. (NASDAQ: TSLA) has a share price of $150.47, and its total EPS for its last four quarters is $3.34. You can calculate its P/E ratio as follows:
150.47/3.34 = 45.05
PepsiCo Inc. (NASDAQ: PEP) has a share price of $179.03 and a total EPS of $6.65. You can calculate its P/E ratio as follows:
179.03/6.65 = 26.92
It’s that simple. All the information needed to calculate a stock’s P/E ratio is readily available to investors. The math is just as simple as shown above.
The P/E Ratio is the Start of Your Stock Research
Now that you know the answer to "How is P/E ratio calculated?", you’re at the beginning of your stock research. P/E ratio is like a batting average in baseball. It’s one of several metrics that investors use in determining whether a stock is valued correctly.
For a complete understanding of P/E ratio, investors need to know about the stock sector, the average P/E ratio for that sector and how the company fits into that sector. You’ll also want to know if you are looking at a trailing or forward price-to-earnings ratio.
Once you do that, you should still combine the P/E ratio with other metrics to get a more accurate sense of a stock’s value.
FAQs
Let's take a look at some of the most frequently asked questions about P/E ratio.
What is a good P/E ratio?
Many factors help you decide if a stock’s P/E ratio is good or bad. One consideration is the P/E ratio compared to other stocks in its sector. This means you’ll want to compare stocks in the same sector. For example, instead of comparing ExxonMobil Corporation (NYSE: XOM) with The Coca-Cola Company (NYSE: KO), you may compare it to Chevron Corporation (NYSE: CVX) — the same sector.
Another consideration is the average P/E ratio for the sector. For example, technology stocks tend to have a higher P/E ratio than utility stocks. Therefore, tech stocks will have higher P/E ratios. To better understand if the stock is a good investment, you’ll want to look at the pace of earnings growth and whether that appears to slow, accelerate or stay the same.
Another factor that may affect a P/E ratio is whether or not a stock pays dividends. Dividends come out of a company’s earnings. You would expect companies that pay dividends to have a lower P/E ratio than stocks that don’t pay dividends.
Why do we calculate P/E ratio?
Why is P/E ratio important? Earnings growth may be the most significant factor in determining if a stock is likely to rise in price. Companies with a history of increasing earnings are more desirable to own. P/E ratio tells investors how much they pay for $1 of those earnings.
What P/E ratio is too low?
Just like trying to assign a good P/E ratio, there are many answers to what makes a P/E ratio too low. When comparing two stocks, value investors will likely lean toward the stock with the lower P/E ratio. Growth investors, on the other hand, may lean toward investing in the stock with a higher P/E ratio.
What if the P/E ratio is negative?
A company with a negative P/E ratio is not profitable — the company is losing money. By itself, this doesn’t mean that you should avoid the stock. Many companies go public while still in the early stages of growth.
It does mean that you have to carefully scrutinize the company’s business model to see how likely it will become profitable and, if so, how long it will take for them to get there. You also want to assess the company’s cash flow situation. In some cases, a company will have to issue new shares or a reverse stock split which is dilutive to shareholder equity.
When analyzing companies with a negative P/E ratio, you may want to look at its price-to-book (P/B) ratio, which assigns a valuation to a company based on its book value — the company’s total assets minus total liabilities. However, this is only useful with companies that have a strong link between their assets and their ability to generate income.
