Price-earnings ratio, also called P/E ratio or referred to simply as PE, is a valuation method used to compare a company’s current share price to its per-share earnings.
PE is a simple number that’s easy to get from two numbers that can be found with the most basic of research. If you can do some basic math, you can calculate price-earnings ratio in your head and amaze your friends.
How to calculate price-earnings ratio
Before we get into the benefits of using price-earnings ratio to pick stocks, here’s an example of how it works:
First, find the current trading price for one share of stock in a company. Then find the earnings per share, or EPS. Divide the price per share by earnings per share and you have the price-earnings ratio:
Market value per share / Earnings per share (EPS) = Price-earnings ratio (PE)
EPS can be calculated a few different ways. It’s most often taken from the last four quarters — called a trailing PE. That can make a lot of sense because it’s for the most recent earnings period and show how much money a company is currently making.
Another EPS calculation is from the earnings expected in the next four quarters — called projected or forward PE. It doesn’t use actual data but is predicting possible outcomes for the stock.
A third method uses the sum of the last two actual quarters and the estimates of the next two quarters.
For sake of argument, we’ll use the trailing PE with earnings from the last four quarters. Here’s an example with real numbers:
If ABC company trades at $100 and has an earnings per share of $5, the calculation is: 100 / 5 = 20.
100 (share price) divided by 5 (EPS) equals a price-earnings ratio of 20.
What price-earnings ratio means
That’s a calculation you can do in your head, though it’s unnecessary with PE available online by looking up a stock price. But it’s what you can do with that number that matters.
While PE doesn’t paint the entire picture of a stock, it helps answer the basic question of if investing in the stock is worth the price. Just remember, trailing PE only tells you what happened in the past, and forward PE is an estimate of projected earnings.
PE is often used to decide if a stock is underpriced, overpriced or somewhere in the middle by comparing the price you pay for it to how much money the stock produces. Strong earnings are proof that a company is doing well, which will drive PE down.
What number is best?
A good rule of thumb when the evaluating price-earnings ratio is to look for a PE of 20, which is what the S&P 500 PE ratio is as of this writing in July 2015. What you’re normally looking for is a low PE.
If a PE for a stock goes up, it means the stock price has risen faster than earnings.
When researching a stock’s PE, take into account the PE of other stocks in that category. Yahoo, for example, breaks down businesses by sector and shows that technology stocks have an overall PE of 20.58. If the stock you’re looking at has a PE that’s double that, the stock may be overvalued.
PE can help determine if a company’s stock is selling for a fraction of what it’s really worth. That’s where the benefit comes in when determining if a stock is undervalued and worth buying.
A company can look overpriced if its PE is higher than the historical average for its sector. It can be underpriced if its PE is a lot lower than the average for its sector, such as among tech stocks.
If two stocks are the same price, for example, but one has a price-earnings ratio that’s half of the other, then the lower PE stock is a better deal because it offers twice the amount of earnings per share. The investor is getting a lot more for their money through higher earnings, even though the stock price is the same.