Before you start investing, you should know a few things about the stock market. One of the most widely known concepts is that you should buy low and sell high, making a profit in the middle. This is a widely-used strategy known as value investing.
But how exactly do you know what a “low” price or a “high” price is?
Successful value investors use a wide range of valuation metrics to determine whether a stock is undervalued, priced at par with its market value, or overvalued.
One of the most commonly used valuation metrics is known as the price-to-earnings ratio, or P/E ratio. The P/E ratio compares the current stock price for shares of a company to the amount of net profits, or earnings, the company generates per year.
The idea is that by comparing how many years’ worth of the company’s earnings it would take to buy the company outright, you can get a good idea of whether the price of the company — and therefore shares of the company — are trading at, below, or above its true market value, also called the intrinsic value.
What Is the Price-to-Earnings Ratio?
In simple terms, the P/E ratio is a valuation metric that helps investors make educated investment decisions. But how does it work?
Price-to-Earnings Ratio Formula and Calculation
The P/E ratio formula is a relatively simple one:
Share Price / Earnings Per Share (EPS) = P/E Ratio
For example, a company’s stock currently trades at $100 per share. The company’s earnings during the past year came in at $20 per share. In this case, you would divide the $100 stock price by the EPS of $20, and you would come to a P/E ratio of 5.
In this example, if the company’s earnings per share remain consistent and you purchase the stock right now, it would take five years for the company to generate enough profits to cover the initial cost of purchasing the share.
In general, stocks that trade at a discount trade with low P/E ratios, while stocks trading at a premium trade at high P/E ratios. Nonetheless, as you will learn below, there are some exceptions to that rule.
Pro tip: You can earn a free share of stock (up to $200 value) when you open a new trading account from Robinhood. With Robinhood, you can customize your portfolio with stocks, ETFs, or cryptocurrencies, plus you can invest in fractional shares.
Different Types of P/E Ratios
When talking about price-to-earnings ratios, investors generally default to the current, or trailing, P/E ratio.
However, there are actually three different P/E ratios that some of the most successful value investors follow, along with a related measurement known as the PEG ratio that takes valuation analysis to the next level.
1. Current or Trailing P/E Ratio
The current, or trailing, P/E ratio is the traditional calculation described above. This P/E ratio compares the current price to the 12-month trailing EPS.
2. Projected or Forward P/E Ratio
The forward P/E ratio is more of a speculative valuation metric because it attempts to predict the future. The idea is that if a company does well, it will grow, and investors can expect more out of future earnings than current earnings.
Therefore, by comparing the current share price to projected future earnings, you get a more detailed view of the current valuation of the company, taking its growth prospects into account.
There are two ways the forward P/E ratio can be calculated:
Current Share Price / Median Guided EPS = Forward P/E Ratio
Using this formula, you would divide the current price per share of the stock by the company’s estimate for EPS in the coming year.
Companies usually provide their expectations — or guidance — for the coming quarter or year in their shareholder reports. In most cases, guidance is displayed as a range. For example, a company may say it expects to earn between $10 and $15 per share over the next year.
Find the center point in the guidance by adding the two extremes together and dividing your total by two. In this case, you would add $10 and $15 to come to $25, then divide $25 by two to come to median guided EPS of $12.50.
You can also use the following formula:
Current Share Price / Analyst Median EPS Expectations = Forward P/E Ratio
Stock market analysts provide all kinds of predictions about publicly traded companies, including where the market price is headed, revenue expectations, and earnings expectations.
Using the formula above, you would ignore the company’s own guided expectations and rely on outside analyst projections, dividing the current share price by the median EPS expectations among analysts that cover the stock.
Of course, these two approaches will generally result in different forward P/E ratios.
3. Mixed P/E Ratio
The mixed P/E ratio, also known as the relative P/E ratio, takes both past earnings and expected future earnings into account using the following formula:
Current Share Price / (Past Two Quarters’ EPS + Future Two Quarters’ EPS) = Mixed P/E Ratio
This formula mixes the two formulas above by using the trailing EPS for the past two quarters rather than the past year and using the forward EPS for the next two quarters rather than the next year.
When calculating the mixed price-to-earnings ratio, you can either use the company’s guided earnings for the next two quarters or the analyst expectations for the next two quarters.
It’s a good general rule of thumb to calculate it both ways for a full understanding of mixed P/E valuation.
4. PEG Ratio
The PEG ratio looks at the price-to-earnings ratio while factoring in growth. The formula for the PEG ratio is:
P/E Ratio / ((Earnings This Year / Earnings Last Year)-1) = PEG Ratio
By factoring in earnings growth, investors get a more accurate picture of whether the stock is overvalued, undervalued, or trading at fair market value.
A PEG ratio of 1 is considered fair market value. When the PEG ratio falls below 1, the stock is considered to be undervalued and likely represents a strong buying opportunity.
Conversely, a PEG ratio above 1 suggests that the stock is overpriced, indicating that you’ll want to look elsewhere to find strong future growth opportunities.
What Does a P/E Ratio of 0 Tell You?
Often when digging into P/E ratios, you’ll find that the ratio is shown as “0.” A P/E ratio of 0 means that the company is currently generating negative earnings, or operating at a loss. Therefore, the P/E ratio cannot be calculated.
Pro tip: Before you add any S&P 500 stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Stock Rover can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
What Is a “Good” P/E Ratio?
There is no static number that acts as a good P/E ratio across the market. Companies in different sectors tend to grow at different rates.
So, to determine if the P/E ratio of the stock suggests over- or undervaluation, it’s important that you look at the average P/E ratio across the sector that particular stock lives in.
Here are the average P/E ratios by sector based on December 2020 readings:
- Technology Stocks P/E Ratio: 59.54
- Service Stocks P/E Ratio: 213.18
- Consumer Staples Stocks P/E Ratio: 50.94
- Energy Stocks P/E Ratio: 0
- Health Care Stocks P/E Ratio: 72.68
- Biotech Stocks P/E Ratio: 49.48
It’s best to check industry averages at the time of your investment; you can use a resource like CSI Market’s valuation by industry to do so.
Is a High P/E Ratio Always a Bad Thing?
Naturally, investors look for lower price-to-earnings ratios when looking for opportunities to buy undervalued stocks at a discount. But is a higher P/E ratio always a bad thing?
P/E ratios are based on the current price of common stock compared to reported earnings over the past year. However, reported earnings and future prospects are two completely different topics.
In the technology and biotech sectors, it’s common to find stocks with what seem to be exorbitantly high P/E ratios. However, these higher ratios are generally justified by expectations of higher earnings.
For example, a biotechnology company currently may be generating little by way of profits but trades with a P/E ratio of 250. Consider that the average P/E ratio of biotech stocks is about 50 at the moment. With a ratio of 250, the stock is obviously overvalued, right?
If the biotechnology company has a new drug application with the FDA for a new cancer therapy that proved to be more effective in clinical trials than the current standard of care, earnings will likely climb dramatically soon when the FDA approves the drug and the treatment hits the market.
Although this type of situation is generally seen in the technology and biotechnology sectors as a result of the industries being driven by innovation, any expectations of a coming blockbuster product, accretive acquisition, or anything else that will drive earnings higher can lead to higher P/E ratios that are entirely justified.
Is a Low P/E Ratio Always a Good Thing?
With the idea being to buy stocks at a low price and sell them at high prices, a low P/E ratio is naturally a good thing — right?
That depends on various factors.
For example, let’s say a technology company is doing relatively well. However, it’s trading with a P/E ratio of 10. That stock has to be a buy, right?
In many cases, yes. However, if the company has failed to innovate and produce compelling new products over the past couple of years, it may be quickly losing market share.
In this case, earnings are expected to fall, so a P/E ratio in line with the overall tech sector simply wouldn’t be justified. The low P/E ratio is more of a warning of painful times to come rather than a red sticker with a discount printed on it.
Is the P/E Ratio the End-All in Valuation Metrics?
Valuation is an interesting topic because the valuation of any stock on the market is relative. The value of anything — whether it be stock, a car, or a slice of pizza — is what someone else is willing to pay for it.
Considering the relativity of valuation, it’s impossible to tie down exactly what the value of any share of stock should be. Nonetheless, successful investors use various valuation metrics to give them an idea of whether they’re getting a good deal when buying shares.
Some of the most common valuation metrics used on Wall Street are listed below.
Other Valuation Metrics to Consider
- Price-to-Sales Ratio. The price-to-sales ratio compares the price of a single share of common stock to the revenue generated from sales by the company over the past year. It’s a strong metric to use with more established companies that are generating consistent revenues.
- Price-to-Book-Value Ratio. Price-to-book-value compares the current price of the stock to the value of assets the company has on its balance sheet. This is an important valuation metric because it gives the investor an idea of what the company would be worth if it was forced to liquidate its assets due to financial instability.
- Price-to-Free-Cash-Flow Ratio. Finally, the price-to-free-cash-flow ratio compares the current price of the stock to the free cash flow generated by the company on an annual basis, providing a comparison of the stock price to the liquid cash the company generates.
As you dive deeper into the stock market, you’ll quickly find that taking the time to understand current valuations of the stocks you’re interested in buying is a fruitful endeavor. At the end of the day, if you are blind to valuation, it’s easy to make the mistake of buying a stock that’s overvalued and doesn’t have much room for growth.
Although the P/E ratio is one of the most widely used valuation metrics, it’s far from the only one. Moreover, considering that valuation is a relative metric, it’s important to use as many tools as possible to get an understanding of the current value of any stock before making a purchase.
In conclusion, valuation is important, but it is only one part of the due diligence process investors should take part in before risking their hard-earned money.
Before buying any stock, make sure to research the company’s financial stability, market penetration, and continued innovation with the goal of cornering the market in the future.