The Price-to-Earnings (P/E) Ratio

The P/E ratio is the most widely quoted valuation metric in investing. It tells you how much investors are willing to pay for each dollar of earnings. [DEFINITION] Price-to-Earnings (P/E) Ratio: A valuation metric comparing a company's stock price to its earnings per share, indicating how much investors pay for each dollar of profit. [FORMULA] P/E Ratio = Stock Price ÷ Earnings Per Share (EPS) ### Understanding P/E A P/E of 20 means investors are paying $20 for every $1 of annual earnings. [EXAMPLE] Apple: - Stock Price: $180 - Earnings Per Share (EPS): $6.00 - P/E = $180 ÷ $6.00 = 30 Investors pay $30 for each dollar of Apple's earnings. That's a premium to the market average (~20). ### Types of P/E **Trailing P/E (TTM):** - Uses past 12 months of actual earnings - Backward-looking but factual - Most commonly quoted **Forward P/E:** - Uses next 12 months of estimated earnings - Forward-looking but uncertain - Based on analyst projections [TIP] Always know which P/E you're looking at. A stock with 25 trailing P/E and 18 forward P/E is expected to grow earnings significantly. ### What P/E Tells You **Low P/E (Under 15):** - Could be undervalued - Or facing problems (slow growth, declining industry) - Requires investigation **Average P/E (15-25):** - Fairly valued for average growth - Market consensus view **High P/E (Over 25):** - Expecting high growth - Or overvalued - Premium for quality [KEY] P/E alone tells you nothing. A P/E of 10 isn't automatically cheap, and P/E of 50 isn't automatically expensive. Context is everything. ### Comparing P/E Ratios Compare P/E to: **1. The Market (S&P 500)** - Historical average: ~15-17 - Current: ~22-25 - Above average suggests optimism (or overvaluation) **2. Industry Peers** | Sector | Typical P/E Range | |--------|------------------| | Tech Growth | 25-50+ | | Consumer Staples | 18-25 | | Banks | 10-15 | | Utilities | 15-20 | | REITs | 15-20 | **3. Its Own History** Is the company trading above or below its 5-year average P/E? [EXAMPLE] Bank of America P/E: 10 Microsoft P/E: 35 Is Bank of America "cheaper"? Not necessarily. Banks typically trade at lower P/Es due to slower growth and cyclical risk. Microsoft commands a premium for growth, stability, and recurring revenue. ### P/E Limitations [WARNING] P/E has significant limitations: - Meaningless for unprofitable companies (can't divide by zero) - Earnings can be manipulated through accounting - Doesn't account for debt levels - Ignores cash on balance sheet - Doesn't reflect growth rate ### The PEG Ratio: Adjusting for Growth [FORMULA] PEG Ratio = P/E ÷ Expected Annual Growth Rate A PEG of 1.0 means P/E equals growth rate—considered "fair value." [EXAMPLE] Two companies: | Metric | Company A | Company B | |--------|-----------|-----------| | P/E | 20 | 40 | | Growth Rate | 10% | 40% | | PEG | 2.0 | 1.0 | Company B has a higher P/E but lower PEG—it's actually cheaper relative to its growth. [EXERCISE] A stock trades at $75 with EPS of $5. The S&P 500 P/E is 20 and this company's sector average P/E is 12. Calculate the P/E and interpret it. |ANSWER| P/E = $75 ÷ $5 = 15. This is below the market average (20) but above the sector average (12). The stock might be fairly valued for its sector, or slightly expensive if sector norms apply. Investigate why it trades above peers. [SCENARIO] You find a stock with P/E of 8—looks cheap! But further research reveals: - Revenue declining 5% annually - Main product losing market share - No clear turnaround strategy The low P/E is justified—the market sees problems ahead. This is a "value trap," not a bargain. Always understand WHY a P/E is low before buying.