Understanding the P/E ratio is an important step in your education of how to best value and choose what stocks you want to buy. With a solid understanding of what a P/E ratio is and how investors use it to assign a relative value to the stock, you gain important insights into a complex part of the stock market. P/E ratio is one of many factors that investors consider when valuing equities — because it includes several indicators of stock performance, it can help make important investment decisions. It's a critical part of learning about stock valuation.
The P/E ratio or price to earnings ratio is a way to measure a company's market price relative to its reported corporate earnings per share. It's a good ratio to use when comparing a stock to others when you're considering investing or selling off a stock.
As a metric, the P/E ratio is defined by taking the market value per share, also known as the price, and dividing it by the earnings per share. Some investors choose to take annual earnings per share by using four quarters worth of earnings, though the ratio can be calculated at any moment in time.
Imagine XYZ Corp has a market value per share of $20. It's annual earnings per share are $1.50, calculating over the past four quarters. That gives XYZ Corp an annualized P/E ratio of 13.3 (20 divided by 1.5). In stock market parlance, that is usually written as 13.3x. It's not expressed in dollars, as there are dollars in both the numerator and denominator. With the P/E ratio, investors can compare companies against one another, regardless of vastly different market values or reported earnings.
The P/E ratio gives helpful insights into how much an investor is willing to pay for each dollar in earnings. Some investors refer to this as the stock's multiple. Many investors use it as a way to determine a stock's value rather than relying solely on the equity's stock price. However, most investors do not rely on P/E alone in comparing the relative value of stocks. It's often combined with other measures to get true insights into investment decisions.
Investors commonly use several other measures in tandem with the P/E ratio. These metrics, along with P/E ratio and their components, can be used to create a better understanding of stocks and when to buy or sell. One metric is company growth rate, which measures how quickly a company has been growing.
Let's look at an example of how to use P/E ratio to compare stocks in the same industry. Imagine that XYZ and ABC companies are both selling at $50 per share. How do you compare them? Look at the earnings per share to help establish the P/E ratio. XYZ has earnings of $20 per share, so its P/E ratio is 2.5x. ABC company has earnings of $5 per share, so its P/E ratio is 10x. In this example, XYZ has a much lower P/E ratio, meaning it's much cheaper to gain a return on each share purchased.
A P/E ratio gives you a deeper understanding of a stock than can be gained just from looking at its market price or earnings per share. It forces investors to take more than a top-level approach to their investment decisions and provides them with a snapshot into actual performance over time.
P/E ratios can be difficult to use to compare stocks in different industrial sectors because some industries have other market factors at play that shape typical P/E ratios among their member companies. 14x is considered a common P/E ratio among financial sector companies. Among tech companies, the average ratio is 20x. Comparing the two with P/E ratio alone is challenging.
P/E ratios are one way to tell if a stock is overvalued or undervalued. But it doesn't give the full picture. You still need to do your homework and understand a company's short- and long-term strategies, its management abilities and its customer base. P/E is one piece in a larger puzzle.
P/E ratios are open to interpretation. They tend to be lower during high inflationary times, for example, because earnings are often artificially distorted. The accounting methods that companies use can also dramatically shape the calculation of earnings per share. Every method has its shortcomings, however, and the P/E ratio is an insightful tool, provided investors use it in the right context.