Understanding the price-to-earnings ratio: What is P/E and how can you use it?

The P/E ratio is one of the most popular metrics that’s used to determine the value of a stock. Find out how to use the price-to-earnings ratio in your trading and investment strategy, and what makes a good P/E ratio.

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What is the P/E ratio?

The price-to-earnings ratio (P/E) ratio shows how the market value of a stock compares to a company’s earnings per share (EPS). While the market value shows us how much someone is willing to pay for a share, the P/E ratio tells us whether that accurately reflects the intrinsic value of the share and the company’s balance sheet.

EPS shows how much each shareholder would earn if the company’s profits were paid out to them, so the P/E ratio indicates how far above its financial health a company’s share is trading. For example, a P/E ratio of 10 means a company’s share price is 10x its earnings.

Earnings and the P/E ratio give investors key insights into how profitable a company is, what its growth journey has looked like and what its future could be.  

Find out how to read a company's earnings report

What does P/E ratio indicate?

The P/E ratio indicates how much market participants are willing to pay for a stock based on its earnings. A high P/E ratio is usually an indication that a stock’s price is high compared to previous or current earnings, which could mean its overvalued. A low P/E ratio shows the opposite, that a company’s current share price is low compared to its earnings.

While P/E ratio is taken as a sign of whether or not the company’s stock price is over or undervalued, on its own it can’t tell us much. The P/E figure needs to be compared to a benchmark or historical P/E range of the company.

There are a lot of other market ratios that can be used in conjunction with the P/E ratio for a more comprehensive overview. For example, the price-to-book ratio compares stock price to book value, while the price-to-sales ratio compares stock price relative to revenue.

Cape ratio vs P/E ratio

The CAPE ratio is a variation of the P/E ratio, which uses EPS over a ten-year period to smooth out fluctuations in profits that could appear over the typical 12-month analysis – believing that the shorter timeframe is too volatile for accurate readings.

It stands for cyclically adjusted price-to-earnings ratio, and was coined by Yale University professor Robert Shiller.

While the P/E ratio is typically used to compare a stock to a competitor or benchmark, the CAPE ratio is used on broader equity indices, to determine whether they entire market is over or undervalued.

What is the average P/E ratio?

The average P/E ratio will depend on the benchmark you’re using to compare a stock to. For the S&P 500 is between 13 and 15. While the average trailing 12-month P/E for the FTSE 100 is 17.55 as of December 2020.

What is considered a high P/E ratio?

A high P/E ratio is a relative term, as there's no specific number that marks the point at which a stock is thought of as expensive. Whether a P/E ratio is high or low will depend on the industry it’s in.

However, in general, stocks with P/E ratios of below 15 are considered cheap, while stocks above about 18 are thought of as overpriced.

Is a high P/E ratio good?

A high P/E ratio is often thought of a good thing as it indicates a growth stock. The expectation of future growth means that investors are more willing to pay for them. While growth stocks are popular, their high volatility creates a risk.

When a company is unlikely to meet investor expectations, it’s considered overvalued and it’s likely at some point the share price will fall to more reasonable levels.

Discover more about overbought stocks

Is a low P/E ratio good?

A low P/E ratio can be a good thing, as they’re usually value stocks. A low P/E ratio is an indication of an undervalued share, as its stock price is low compared to its actual intrinsic value. This discrepancy can be a bargain for investors who want to buy the shares when they’re cheap and take advantage of the market correction.

However, it’s also worth noting that there can be other factors coming into play such as less potential growth and accounting discrepancies, so it’s always worth comparing a company to those in its industry.

What’s considered a low P/E ratio will also vary across industries, so you’ll need to research what the average is.

Learn about how to find oversold stocks

How to calculate P/E ratio

You calculate the P/E ratio by dividing the market value of a share by the company’s earnings per share. This equation looks like:

P/E ratio = share price/earnings per share

P/E ratio example: Tesla P/E ratio

Say Tesla’s EPS is 1.33 and its share price is trading at $686, this would give TSLA a P/E ratio of 515.78. This means Tesla’s shares would be trading at 515.78 times the earnings investors receive.

While the main assumption in this example could be that TSLA stock is overvalued and could experience short-term volatility, it’s also indicative that people are willing to pay above the odds to hold TSLA shares based on expectations for future profitability.

You’d then compared this figure to an industry benchmark to see if Tesla was trading above or below average. For example, if the US Auto sector on the S&P 500 had an average P/E ratio of 164.37, TSLA would be trading well above the benchmark. 

See a history of Tesla's share price

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