Stocks with high price-to-earnings (P/E) ratios can be overpriced. So, is a stock with a lower P/E ratio always a better investment than a stock with a higher one? The short answer is no. The long answer is that it depends on the situation. Read on to find out more about price-to-earnings ratios, how to interpret them, the difference between a low and a high P/E ratio, and which one is better.
Key Takeaways
- The P/E ratio is calculated as a stock’s current share price divided by its earnings per share for a 12-month period.
- A stock trading at $40 per share with an EPS of $2 has a P/E ratio of 20, while a stock trading at $40 per share with an EPS of $1 has a P/E ratio of 40, meaning the investor pays $40 to claim $1 in earnings.
- P/E ratios tend to vary from industry to industry, so it is important to compare companies from the same industry and with similar characteristics.
What Is a Price-to-Earning (P/E) Ratio?
The P/E ratio is calculated as a stock’s current share price divided by its earnings per share (EPS), usually for the last 12 months—also called the trailing 12 months (TTM). Most of the P/E ratios you see for publicly-traded stocks are an expression of the stock’s current price compared with its previous 12 months of earnings.
Stocks with high price-to-earning (P/E) ratios can be overpriced.
A stock trading at $40 per share with an EPS of $2 would have a P/E ratio of 20 ($40 divided by $2), as would a stock priced at $20 per share with an EPS of $1 ($20 divided by $1). These two stocks have the same price-to-earnings valuation. In both cases, investors pay $20 for each $1 of earnings.
However, what if a stock earning $1 per share was trading at $40 per share? Then we’d have a P/E ratio of 40 instead of 20, which means the investor would be paying $40 to claim a mere $1 of earnings. This seems like a bad deal, but there are several factors that could mitigate this apparent overpricing problem.
First, the company could be expected to grow revenues and earnings much more quickly in the future than companies with a P/E of 20, thus commanding a higher price today for the higher future earnings. Second, suppose the estimated (trailing) earnings of the 40-P/E company are very certain to materialize, whereas the 20-P/E company’s future earnings are somewhat uncertain, indicating a higher investment risk.
Investors would incur less risk by investing in more-certain earnings instead of less-certain ones, so the company producing those sure earnings again commands a higher price today.
Comparisons Are Necessary
It must also be noted that average P/E ratios tend to vary from industry to industry. Typically, companies in very stable, mature industries that have more moderate growth potential have lower P/E ratios than companies in relatively young, quick-growing industries with robust future possibilities.
Thus, when an investor is comparing P/E ratios from two companies as potential investments, it is important to compare companies from the same industry and with similar characteristics. Otherwise, if an investor simply purchased stocks with the lowest P/E ratios, they would likely end up with a portfolio full of utilities stocks and similar companies, which would leave the portfolio poorly diversified and exposed to more risk than if it had been diversified into other industries with higher-than-average P/E ratios.
However, this doesn’t mean that stocks with high P/E ratios cannot turn out to be good investments. Suppose the same company mentioned earlier with a 40-P/E ratio (stock at $40, earned $1 per share last year) was widely expected to earn $4 per share in the coming year. This would mean (if the stock price didn’t change) that the company would have a P/E ratio of only 10 in one year’s time ($40 divided by $4), making it appear very inexpensive.
The Bottom Line
The important thing to remember when looking at P/E ratios as part of your stock analysis is to consider what premium you are paying for a company’s earnings today and determine if the expected growth warrants the premium. Also, compare the company to its industry peers to see its relative valuation to determine whether the premium is worth the cost of the investment.
FAQs
Stocks with high price-to-earnings (P/E) ratios can be overpriced. So, is a stock with a lower P/E ratio always a better investment than a stock with a higher one? The short answer is no. The long answer is that it depends on the situation.
Is a low PE ratio always good? ›
P/E ratio, or price-to-earnings ratio, is a quick way to see if a stock is undervalued or overvalued. And so generally speaking, the lower the P/E ratio is, the better it is for both the business and potential investors. The metric is the stock price of a company divided by its earnings per share.
Does the PE ratio really matter that much? ›
The Bottom Line
While P/E ratios are not the magical prognostic tool some once thought they were, they can still be valuable when used the properly. Remember to compare P/E ratios within a single industry, and while a particularly high or low ratio may not spell disaster, it is a sign worth taking into consideration.
Do low PE stocks outperform high PE stocks? ›
A higher PE suggests high expectations for future growth, perhaps because the company is small or is an a rapidly expanding market. For others, a low PE is preferred, since it suggests expectations are not too high and the company is more likely to outperform earnings forecasts.
Why can PE ratios be misleading? ›
A high P/E ratio may suggest that investors are expecting higher earnings in the future. The P/E ratio can be misleading because it is either based on past data or projected future data (neither of which are reliable) or possibly manipulated accounting data.
What is the ideal PE ratio to buy? ›
Average PE of Nifty in the last 20 years was around 20.* So PEs below 20 may provide good investment opportunities; lower the PE below 20, more attractive the investment potential.
What does PE ratio tell you? ›
Price to earnings ratio, or P/E, is a way to value a company by comparing the price of a stock to its earnings. The P/E equals the price of a share of stock, divided by the company's earnings-per-share. It tells you how much you are paying for each dollar of earnings.
What PE ratio does Warren Buffett use? ›
With those two breadcrumbs, we see that Buffett has historically paid PE ratios of somewhere 11-15 times, which translates Ricky into earnings yields, earnings yields are just the inverse of the PE ratio of roughly 7-9 percent. These are low below market average valuations, that's the big takeaway so far, Ricky.
Why is PE ratio not a good indicator? ›
The biggest limitation of the P/E ratio: It tells investors next to nothing about the company's EPS growth prospects. If the company is growing quickly, you will be comfortable buying it even it had a high P/E ratio, knowing that growth in EPS will bring the P/E back down to a lower level.
What is an overrated PE ratio? ›
Stocks with high price-to-earning (P/E) ratios can be overpriced. A stock trading at $40 per share with an EPS of $2 would have a P/E ratio of 20 ($40 divided by $2), as would a stock priced at $20 per share with an EPS of $1 ($20 divided by $1). These two stocks have the same price-to-earnings valuation.
In general, a high P/E suggests that investors expect higher earnings growth than those with a lower P/E. A low P/E can indicate that a company is undervalued or that a firm is doing exceptionally well relative to its past performance.
Does PE outperform S&P 500? ›
Between 2000 and 2020, private equity outperformed the Russell 2000, the S&P 500, and venture capital.
What is the PE ratio of a Tesla? ›
As of today (2024-05-29), Tesla's share price is $176.19. Tesla's Earnings per Share (Diluted) for the trailing twelve months (TTM) ended in Mar. 2024 was $3.92. Therefore, Tesla's PE Ratio (TTM) for today is 44.95.
Why is PE not a good indicator? ›
PE ratios are commonly used as a metric to determine "value". However, PE ratios are unreliable for a number of reasons and earnings actually have no correlation with valuations. Return on invested capital is a better measure of value and has significant correlation with valuation.
Why is Amazon's PE ratio so high? ›
Why is Amazon PE Ratio so high? Amazon's P/E ratio is higher than most companies in the retail industry because investors are optimistic about its future growth potential. As mentioned, a high price multiple can indicate the market expects higher growth from a company.
Why is PE ratio meaningless? ›
For some companies, the P/E ratio is meaningless
You see, the problem with the P/E ratio is that it's a retroactive metric. It pits a company's current market cap against its trailing-12-month profit. But when you buy shares of a company, you're not purchasing its history -- you're purchasing its future cash flows.
Is a PE ratio of 30 good or bad? ›
A P/E of 30 is high by historical stock market standards. This type of valuation is usually placed on only the fastest-growing companies by investors in the company's early stages of growth. Once a company becomes more mature, it will grow more slowly and the P/E tends to decline.
Is a PE ratio of 200 bad? ›
A P/E ratio of 200 is high. But it is basically saying that people expect the company to grow earnings to be 15 to 20 times as large as they are now (so the P/E ratio would be 10 to 15). If you don't think that the company has that kind of potential, don't invest.
Is a negative P/E ratio good or bad? ›
A negative P/E ratio means the company has negative earnings or is losing money.
Why do car companies have low PE ratios? ›
Answer and Explanation: Automobile and airline stocks traditionally have low P/E ratios because they are both capital intensive industries with thin margins (low earnings).
