If you’ve ever heard investment professionals speak their language, you’ve probably heard them drop the term “PE ratio” like nobody’s business. It’s OK if it went in one ear and out the other. PE ratio refers to price-to-earnings ratio, and it’s a factor that many investors use to judge whether an individual stock is worth buying.
Here, we take a closer look at what a price-to-earnings ratio is, how it’s calculated and what makes for a good PE ratio.
What is a price-to-earnings ratio?
The price-to-earnings ratio is a formula that allows investors to value a company and attempt to determine if that company is overvalued, undervalued or fairly valued. It measures a company’s share price against the company’s earnings per share (EPS).
The formula to calculate a company’s PE ratio is SP/EPS (share price / earnings per share).
How to calculate a company’s PE ratio
It's important to know that a company’s PE ratio can be calculated using either the company’s projected earnings over the next 12 months (forward PE ratio) or the company’s reported earnings over the previous 12 months (trailing PE ratio). Investors often consider both metrics to understand a company’s past performance against its expected future performance.
You can find a company’s reported EPS in its most recent earnings report. Projected EPS is often supplied by stock analysts, especially for widely followed stocks. However, you need to keep in mind that a company can miss projections, which could render your calculations of forward PE incorrect.
To calculate a company’s PE ratio, simply divide its current share price by its EPS, whether reported or projected.
What is a good PE ratio?
There is no magic number that indicates a “good” PE ratio across the board. Generally, a company with a lower PE ratio will be less expensive than a company with a higher PE ratio.
But investors rarely rely solely upon a company’s PE ratio when deciding whether to invest in a stock. Instead, they often leverage the ratio to help perform comparisons against things like:
- A company’s growth prospects: Companies with high growth potential tend to exhibit higher PE ratios compared to companies with lower growth potential. Therefore, growth stocks tend to have higher PE ratios compared to more established companies. If a company’s current PE ratio is significantly higher or lower than its projected PE ratio, it may indicate that the company is overvalued or undervalued.
- A company’s peers: Peers operating within the same industry and that have similar growth rates tend to have similar PE ratios. If a company has a PE ratio that is significantly higher than its peers with no clear explanation why, it may indicate that the stock has become overvalued. Conversely, if the company has a PE ratio that is significantly lower than its peers with no clear explanation why, it may indicate that the stock is undervalued.
- A stock’s historical performance: A company’s PE ratio will fluctuate over time depending on its performance and other factors. If a company’s PE ratio is currently dramatically higher or lower than its historical average, it’s important to understand why, as it may indicate that the stock has become overvalued or undervalued based on historical precedent—or that it is undergoing a period of change.
A high PE ratio doesn’t always mean that a stock is overvalued. It could simply indicate that investors expect the company to bring in higher earnings in the future. Similarly, while a low PE ratio may indicate that a stock has become undervalued, it could also indicate that investors believe a company will see its earnings decline in the future. Or investors may have other concerns, such as a recent scandal, business risk or poor performance.
A company’s price-to-earnings ratio does not communicate the why behind a company’s valuation. It’s up to the investor to look at the PE ratio and dive deeper to understand whether there are legitimate reasons for a company’s ratio to be higher or lower than would be expected.
PE ratio is just one way of measuring a company’s performance
If you’re considering adding individual stocks to your portfolio, learning how to interpret a company’s PE ratio can be a useful skill.
But it’s important to remember that the PE ratio should not be your only means of evaluating potential investments. Other measurements, such as a company’s price-to-sales ratio, debt-to-equity ratio and return on equity, offer additional insights that can help you make a more informed decision.
A financial advisor can help evaluate your investments
If you’re unsure about your ability to thoroughly vet your investments, working with a financial advisor to build and manage your portfolio is an excellent alternative. These professionals can help you build a financial plan that will work toward your financial goals and can help you evaluate investments you are considering.
All investments carry some level of risk including the potential loss of all money invested.