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eToroPrice-to-Earnings (P/E) Ratio: Definition + How to Use it
Written by Brian Nibley
Fact-checked by Joey Shadeck
Edited by Jeff Anberg
One of the simplest and most common ways to evaluate a stock involves looking at its price-to-earnings ratio (P/E ratio). This ratio provides insight into a company’s current stock price in relation to its earnings. Is the current price high or low compared to earnings? That’s what the P/E ratio is designed to measure.
The price-to-earnings ratio meaning isn’t difficult to understand. It’s a simple metric derived from a simple equation. That said, there are many variations, alternatives, and factors that must be taken into consideration when interpreting this ratio and using it to evaluate a stock. This guide will take you through an overview of each of these elements and help you better understand how to use them when analyzing a stock.
What is the Price-to-Earnings (P/E) ratio?
The price-to-earnings ratio, also referred to as the price-earnings multiple, describes how much money a company is making compared to the price of its stock. It is a common metric used to help discern a company's value at its current share price.
Earnings are an important factor to consider when evaluating a company’s stock. Investors want to know how profitable a company is right now and how profitable it might be in the future.
Companies that have high earnings relative to their current share price (low P/E ratio) could be undervalued, as they’re more profitable than the market is currently pricing in. Meanwhile, companies with higher share prices but lower earnings (high P/E ratio) could be overvalued, as the market may be overestimating how profitable the company is or will be in the future.
If a company doesn’t grow and its earnings stay flat, the P/E ratio can also be interpreted as the number of years it’ll likely take before it pays back the amount paid per share.
P/E comes in two different forms: forward and trailing. A trailing P/E ratio is based on previously reported earnings per share, while a forward P/E ratio is when earnings per share (EPS) figures are based on projections of future earnings.
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Forward price-to-earnings
Forward P/E is based on future projections of a company’s growth provided by the management team. Forward P/E is usually calculated by dividing the current share price by the estimated following fiscal or calendar year of EPS. This can be useful because past performance doesn’t always predict future results with great accuracy.
At the same time, the predictions of future growth are only estimates and could very well be flawed.
Trailing price-to-earnings
Trailing P/E is the opposite of forward P/E. Instead of dividing the current stock price by an estimate of the next twelve months’ earnings, you divide the stock price by the actual EPS of the previous twelve months.
This provides a snapshot of how willing investors have been to buy the stock based on real performance during the past year. The limitation is that future growth prospects could change, and trailing P/E does not consider this.
P/E ratio formula and calculation
There are several different ways to calculate the price-to-earnings ratio, including:
- P/E = Stock price per share / earnings per share
- P/E = Market capitalization / total net earnings (the same ratio as the first, but scaled to the company-wide level instead of per-share)
- Justified P/E = dividend payout ratio / (required rate of return - sustainable growth rate)
The justified P/E ratio helps determine the optimal P/E ratio that an investor should pay based on a company’s growth rate, retention and dividend policies, and the investor’s required rate of return. Comparing justified P/E to basic P/E is a common stock valuation method.
How to analyze a P/E ratio
While P/E is a simple metric to calculate, analyzing a P/E ratio can be difficult. The value’s meaning can change based on the status of the company and current market sentiment.
Excessively high P/E ratios can sometimes indicate that a stock is overbought, meaning investors buy shares despite the company not increasing its earnings. However, this isn’t always the case. Some stocks can have high P/E ratios compared to their industry’s historical average and still see share price appreciation for many years. This usually happens when the market believes a company will be more profitable in the future, although it sometimes can be a sign of a speculative bubble forming as well.
A P/E ratio by itself is not very informative without further context. The number needs to be compared to the company’s historical P/E or to competitors in the same industry.
P/E ratio example
Suppose you want to calculate the P/E ratio for Company X.
| Company X | |
| Stock Price | $50 |
| Earnings Per Share (EPS) | $5 |
Calculating a P/E ratio
The formula for the P/E Ratio is:
P/E Ratio = Price per Share / Earnings per Share (EPS)
Plugging in the values:
P/E Ratio = 50 / 5 = 10
Company X has a P/E ratio of 10, which means investors are willing to pay $10 for every $1 of the company's earnings. Other than that, it’s hard to gain any insight into the stock from the P/E ratio alone. We would need to make historical comparisons to what P/E the company has had in the past and look at the P/E of the company’s competitors.
The CAPE ratio
The CAP/E ratio or the Shiller P/E ratio, which was popularized by economist Robert Shiller, is another useful metric when applied to the market as a whole. The CAPE ratio is calculated by dividing the current price of a stock or market index by the average real earnings over the past 10 years, adjusted for inflation.
The CAPE ratio is often used to gauge market cycles, helping investors identify potential bubbles or periods of undervaluation. A high CAPE ratio might suggest that the market is overpriced relative to its historical earnings, while a low CAPE ratio could indicate the opposite.
The CAPE ratio is mostly used for analyzing broad market indices, such as the S&P 500, rather than individual stocks.
P/E vs PEG ratio
The PEG (price/earnings growth) ratio takes into account not only a stock's P/E ratio but also its expected earnings growth. PEG can give investors a more comprehensive take on a stock’s potential and whether it’s undervalued or overvalued compared to companies in the same industry with similar growth prospects.
The PEG ratio tends to be most useful when examining companies in high-growth industries, where P/E ratios alone might appear to be on the higher side. A PEG ratio of 1 or less usually indicates that a stock may be undervalued or trading at fair value based on its growth potential.
For example, let’s compare two companies, Company A and Company B, and assume they are both in the tech sector.
| Metric | Company A | Company B |
| Price (P) | $100 | $150 |
| Earnings Per Share (EPS) | $5 | $10 |
| P/E Ratio | 20 | 15 |
| Earnings Growth Rate (%) | 20% | 5% |
| PEG Ratio | 1.0 | 3.0 |
Company A has a P/E ratio of 20 and an expected earnings growth rate of 20%. Its PEG ratio is 1.0 (P/E ratio ÷ growth rate = 20 ÷ 20 = 1.0).
Company B has a lower P/E ratio of 15 but a slower growth rate of 5%. Its PEG ratio is 3.0 (P/E ratio ÷ growth rate = 15 ÷ 5 = 3.0).
Even though Company B’s P/E ratio is lower, its higher PEG ratio suggests that the stock could be less attractive than Company A when considering future growth prospects. Company A’s PEG ratio of 1 suggests the company is fairly valued, or perhaps undervalued, based on its potential for growth.
P/E ratio limitations
One limitation of the P/E ratio is that while it may be an objective value, it’s still open to interpretation. The P/E ratio meaning can be seen in multiple ways depending on various factors.
Figuring out a stock’s true value can’t be done by simply looking at its most recent earnings year. A corporation's predicted future cash flows and earnings must be taken into account.
The Price-to-Earnings Ratio is a helpful place to start. However, by itself, it's difficult to draw actionable conclusions until we know more about the company's risk profile and growth prospects for EPS. To better understand a firm's worth and performance, an investor needs to examine the company's financial statements in greater detail and employ additional techniques for financial analysis and valuation.
P/E ratio alternatives
Here are some common alternatives to the P/E ratio that investors may use to evaluate a company's financial health and try to determine if the stock is undervalued or not:
- Price-to-Book (P/B) Ratio: This ratio compares a company's market value to its book value (assets minus liabilities), helping to assess whether a stock is undervalued or overvalued.
- Price-to-Sales (P/S) Ratio: This ratio measures the price of a company's stock relative to its revenue per share. It can be especially useful for evaluating companies that aren't yet profitable.
- Enterprise Value to EBITDA (EV/EBITDA): Compares a company’s enterprise value (market cap, + debt, - cash) to its EBITDA (earnings before interest, taxes, depreciation, and amortization).
- Return on Equity (ROE): Assesses how effectively a company uses its equity to generate profits, helping investors gauge financial efficiency and profitability.
- Free Cash Flow Yield: Compares a company's free cash flow to its market capitalization, providing insight into its ability to generate cash and return value to shareholders.
| Ratio | Description |
| Trailing P/E Ratio | Compares current stock price to earnings per share (EPS) over the past 12 months. |
| Forward P/E Ratio | Compares current stock price to estimated future earnings per share (EPS). |
| CAPE Ratio | Uses a 10-year average of real earnings, adjusted for inflation, to assess market valuation. |
| Price-to-Book (P/B) Ratio | Compares a company's market value to its book value (assets minus liabilities) to evaluate under or overvaluation. |
| Price-to-Sales (P/S) Ratio | Measures the price of a company's stock relative to its revenue per share, useful for unprofitable companies. |
| Enterprise Value to EBITDA (EV/EBITDA) | Compares a company’s enterprise value (market cap plus debt minus cash) to its EBITDA, often used for capital-intensive industries. |
| Return on Equity (ROE) | Assesses how effectively a company uses its equity to generate profits, indicating financial efficiency. |
| Free Cash Flow Yield | Compares a company's free cash flow to its market cap, indicating its ability to generate cash and return value to shareholders. |
FAQs
What is a good price-to-earnings ratio?
In general, a lower P/E ratio is thought to be better, as this could indicate that a stock is cheap relative to its earnings potential. However, a high P/E ratio could also be seen as positive, as it could indicate that investors believe the company’s earnings will grow in the future. Remember that the numbers can be interpreted differently for many reasons. For a P/E ratio to have any significant meaning, it must be compared to that of other companies in the same industry or past P/E numbers of the same company.
The P/E ratio can also be used to determine whether a stock is a growth stock or a value stock. Companies with chronically high P/E ratios are considered to be growth stocks. Investors have a high degree of confidence that these companies will continue growing.
Companies with P/E ratios that always seem to be on the lower side are considered value stocks. They are seen as undervalued because their share price trades lower than their fundamentals suggest would be appropriate. It’s every investor’s dream to find such a stock and buy it before the broader market corrects the price, as when they do, those who bought the stock when it was undervalued stand to profit.
What does a negative P/E ratio mean?
A negative P/E ratio usually means that a company is experiencing financial losses. To have a negative P/E ratio, a company must have reported negative earnings. Because the P/E ratio is calculated by dividing the stock’s current price by earnings per share (EPS), and negative EPS results in negative P/E, it indicates that a company is not currently profitable.
Investors might see a negative P/E ratio as a red flag, thinking the company could be in deep trouble. However, in some cases, it could also mean the company is investing heavily in growth, expecting future profits.
What is the difference between forward P/E and trailing P/E?
Trailing P/E is based on previously reported EPS numbers. Forward P/E is based on future estimates of EPS, which are usually derived from equity research analysis or projections provided by a company’s management team.
What does it mean if a company has a high P/E ratio?
A high P/E ratio generally means that investors are willing to pay a premium for the company's earnings, often because they expect the company to continue growing in the future. It suggests that the market has high confidence in the company's potential to increase profits over time. However, a high P/E ratio can also signal that a stock may be overvalued, meaning the share price could have gotten ahead of itself compared to other companies in the same industry.
For this reason, investors need to be careful not to look at P/E ratios in a vacuum. They are only one tool used to conduct analysis, and taken alone, they could create a misleading picture.
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About the Editorial Team
Brian Nibley is a copywriter and journalist who has been writing about fintech and finance-related topics since 2017. His work has appeared in publications such as MSN Money, Business Insider, Cointelegraph, BitPay, and Finance Magnates.
Joey Shadeck is the Content Strategist and Research Analyst for StockBrokers.com. He holds dual degrees in Finance and Marketing from Oakland University, and has been an active trader and investor for close to 10 years. An industry veteran, Joey obtains and verifies data, conducts research, and analyzes and validates our content.
Jeff Anberg is a Staff Editor at StockBrokers.com. Along with years of experience in media distribution at a global newsroom, Jeff has a versatile knowledge base encompassing the technology and financial markets. He is a long-time active investor and engages in research on emerging markets like cryptocurrency. Jeff holds a Bachelor’s Degree in English Literature with a minor in Philosophy from San Francisco State University.