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By Rebecca Hotsko • Published: • 14 min read
One of the most commonly used metrics for evaluating a company’s stock is the price-to-earnings ratio (P/E ratio). In this article, we’ll take a closer look at what the P/E ratio is, how to calculate it, and how to use it to make informed investment decisions.
TABLE OF CONTENTS
I. What is the P/E Ratio?
II. P/E Ratio Formula and Calculation
III. What is Forward P/E Ratio?
IV. How can you use the P/E Ratio?
V. Frequently Asked Questions About P/E Ratio?
WHAT IS THE P/E RATIO?
The P/E ratio tells us how much investors are willing to pay for $1 dollar of a company’s earnings, and reflects investor’s expectations of future earnings growth.
For example, if a company has a share price of $100 and earnings of $5, it has a P/E of 20. This tells us that the shares of this company are currently trading for 20x its current earnings. By itself, this number doesn’t tell us a lot, as it needs to be compared to the company’s historical P/E range, the industry average, as well as the company’s future growth prospects to get a better sense if that multiple seems justified to pay for the company today.
In general, a higher P/E ratio suggests that investors are expecting higher earnings growth in the future.
Another way to look at this ratio is by inverting it. When inverted, this ratio is called the earnings yield which tells us the expected return for every dollar invested in the company.
Earnings Yield = Earnings Per Share (EPS) / Share Price
Using the same example, a company with a P/E of 20, would have an earnings yield of 1/20 = 5%.
This can be a useful tool for comparing potential returns between investments. The higher the P/E, the lower the earnings yield will be.
P/E RATIO FORMULA AND CALCULATION
A company’s P/E can be estimated on a trailing or forward basis.
The trailing P/E ratio is found by taking the current share price of a stock and dividing it by the company’s reported EPS for the last 12 months (also referred to as trailing 12 month earnings).
Trailing P/E Ratio = Current Share Price / Historical EPS
However, the trailing P/E also has its drawbacks, particularly during an economic contraction when a company’s earnings are under pressure. During this time, the earnings of a company typically decline, and as a result, the valuation may actually rise if the stock price doesn’t adjust down by the same amount.
Second, because the trailing P/E is based on historical earnings, sometimes it is not reasonable to expect that will continue into the future.
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WHAT IS FORWARD P/E RATIO?
The forward P/E ratio is calculated as the current share price divided by the projected earnings per share for the next 12 months. These earnings forecasts are typically provided by analysts and based on their estimated EPS over the next 12 months.
Forward P/E Ratio = Current Share Price / Forecasted EPS
Generally, investors tend to focus more on the trailing P/E because it is what the company has actually earned. Whereas, the forward P/E uses estimates of future earnings that come from analysts which historically, have been shown to be optimistic, especially when estimating quarterly results. This can lead to the forward P/E being understated at times, particularly if analysts are overestimating EPS growth for the company.
If the forward P/E ratio for a company is higher than the trailing P/E, this means that the company is expected to have higher growth in EPS over the next 12 months compared to the previous 12 months.
Looking at a real life example: Google stock is currently trading at a trailing P/E of 23.8 while its forward P/E is 17.7. Within the last 5 years, Google has traded within a P/E range of 15.5 – 54.5. The industry average P/E for similar companies is 26.2. The S&P 500 average P/E is 23.7.
The current P/E for Google tells us that the market is currently willing to pay 23.8x Google’s current earnings to buy a share in the company. We can also see that Google is currently trading for a slight discount to the industry average of 26.2x and is trading in the mid range of its own 5-year history.
The next thing to look at is the growth rate expected in EPS going forward, as one reason as to why Google may be trading at a discount to the industry average and lower than it’s traded in previous years, is because the market expects its future earnings growth to slow going forward, thereby justifying a lower multiple.
Using our TIP Finance tool, I can see that Google’s past 5 year average EPS was 38.12%, so the market may be pricing in their earnings growth to slow, which means that Google wouldn’t warrant as high of a multiple as it once did when it was growing at such high rates. This suspicion is confirmed when looking at Google’s current estimate for the next 5-year growth in EPS of 16.3%, much lower than the past 5 years rate of 38.12%.
I also like to compare the forward P/E to the current P/E to get a sense of analysts’ next year estimates of growth in EPS and see if that seems reasonable. Because Google’s forward P/E is less than its current P/E, (17.7x vs 23.8x) this means that analysts forecast next year’s EPS growth to be greater than the previous year. This checks out as analysts are currently expecting growth in EPS over the next year to be 19.8%, while growth over the past year was -18.6%.
These are just some of the ways I incorporate using the P/E multiples as a tool in my valuation analysis when assessing a stock. Another important piece to consider is where that multiple may be in the future, as you will need to apply a future multiple when performing your intrinsic value analysis of a stock and you will need to have some estimate of what that future multiple may be.
In general, while it’s impossible to predict where a future price multiple will be, history shows that price multiples tend to mean revert over time.This means that if you are paying a premium multiple for a company, one that is well above its industry average and within the high range of its own history, then you should expect that as the company matures over time, that multiple will also have to come down to a more average range.
In the case of Google, where it is currently trading slightly below the industry average, this stock may actually benefit from a bit of multiple expansion over time if their EPS growth were to pick up in the future.
If you are stuck on what multiple and growth rates to use, I highly recommend checking out Aswath Damodaran as he publishes these data sets on his website.
HOW CAN YOU USE THE P/E RATIO?
The P/E ratio is a useful tool in valuation analysis as it helps us compare the relative valuation of a company and tells us the market’s expectations of future growth of a stock. However, the P/E ratio alone does not tell us whether a stock is over or undervalued. An investor must perform a discounted cash flow or some type of intrinsic value analysis to get an estimate of what the company is worth to determine if the company is over/undervalued.
Just because a company is trading for a higher P/E relative to its peer group and own history does not necessarily mean it’s overvalued, if that price is justified.
For example, a high P/E ratio may indicate that investors are optimistic about a company’s future earnings potential, such is the case with Tesla, which trades at 47.5x earnings compared to the industry multiple which is around 10.3x earnings. This high multiple tells us that the market expects Tesla’s future growth to far outpace the industry average of other automakers, and because of that, market participants are willing to pay a hefty premium for these shares and this future growth prospect.
To confirm this, the current next year growth estimate for Tesla’s EPS is 42.5%, compared to the industry average of 16%. This tells us that the market is pricing Tesla at a premium based on the expectation that it will deliver strong (and above industry average) growth in the future.
Again, just looking at the P/E alone won’t tell us whether Tesla is overvalued or undervalued at today’s price. To determine if Tesla stock is overvalued at this price, an investor needs to come to an estimate of the intrinsic value of the stock.
If you are a beginner investor, I highly recommend checking our Ultimate Stock Investing Guide for Beginners as a good place to start.
FREQUENTLY ASKED QUESTIONS ABOUT P/E RATIO
What is a good PE ratio?
A “good” P/E ratio is subjective and can vary depending on the industry and the growth prospects. Some industries have higher P/E ratios because the growth prospects are higher. For example, oil and gas companies have an industry P/E of 6.3 while technology companies have an industry P/E of 26, on average. In general, when comparing the P/E of a company with the industry average, investors should not mistake a low P/E as a company being “undervalued.” A lower P/E ratio may indicate that this company has lower growth prospects than the rest of its competitors and that is why it is trading for a lower multiple. While there isn’t an optimal P/E a company should trade for, the more important message is that price multiples tend to be very mean reverting over time. This means that paying too high of a multiple today for a company will hurt your future returns as the multiple mean reverts back to its average over time as the company matures.
Is a high PE ratio good?
A high P/E ratio may indicate that investors are optimistic about a company’s future growth prospects. A high P/E for a company or industry may be justifiably higher because of these high future growth prospects, low interest rates, or low inflation. It’s important to compare a company’s P/E to its own history, the stage in its life cycle, as well as its industry average to determine if the P/E ratio is good or not. In general, P/E multiples tend to be very mean reverting, so if you pay too high of a price for a company, over time as the company matures, this multiple will revert to the industry average and will negatively impact your returns.
Why is the P/E Ratio important?
The P/E ratio is important because it is a simple tool that provides insight into a company’s relative valuation and growth potential. It can also be used as a tool for comparing companies in the same sector or industry. The P/E ratio is just one valuation metric or price multiple that can be used to assess the relative valuation of a company. However, there are some cases where the P/E multiple may not be appropriate to use for all companies, such as in early stage companies, or stocks that have negative earnings.
What is a bad PE Ratio?
A bad P/E ratio is subjective and will be different depending on the company and the industry it’s in. In general, a P/E ratio of a company that is much higher than its competitors may be justified if the company has much higher growth prospects, or a better competitive position than its peers. That’s why it’s always important to dig into whether the multiple is justified or not, as that is key to your understanding of whether that company warrants that higher multiple and if it’s over valued or not.
As Chris Mayer talks about in his book on how to find 100 Bagger Stocks, some stocks that have gone on to 100x their returns always looked expensive, yet they kept compounding over time.
Take Amazon, for instance, which always appeared expensive to investors but still managed to compound over time and become a 100 bagger. Between 1997 and 2017, Amazon’s EPS grew at an average annual rate of 36%, while its P/E multiple remained consistently high and always looked expensive relative to its own history and especially its peers. In cases like these, it’s important to look beyond the traditional metrics and focus on the company’s long-term potential for growth and innovation.
Why is Tesla PE ratio so high?
Tesla’s P/E is currently 47.5 while the industry average is 10.3. Tesla’s P/E multiple could be higher than its industry competitors due to several factors. First, investors have likely placed much higher growth prospects on Tesla than other automakers. Elon Musk has stated that he sees a potential path for Tesla to be worth more than Apple and Saudi Aramco combined, which if investors believe this growth story, would warrant the high multiple paid today. Tesla has positioned itself as a leader in the electric vehicle market and has also expanded into other areas, such as energy storage and solar power. To do this, Tesla spends a lot of money on capital expenditures and because of this reduces its current earnings which makes the P/E ratio higher.
Is 5 a good PE ratio?
A P/E ratio of 5 could be considered good or bad depending on the industry and the company’s growth prospects. For example, the industry average P/E for oil and gas companies is 6.3. This means that if an E&P company is trading for below that, the company is currently priced cheaper than the industry average. This does not automatically mean the lower P/E stock is a better buy just because it is trading below the industry average, as it may be justifiably cheaper because it has worse growth prospects than its competitors or a deteriorating financial position.
It is also important to look at the company’s own history, as well as future prospects to understand more about whether that multiple means the company is a fair price to pay or not.
For example, if that same company used to trade at a premium to the market of 8x earnings but recently has declined, then that may be a great opportunity to dig into and learn more about the reasons behind the recent decline as this company could be a good candidate for earning a return on mean reversion of the multiple. As research shows that mean reversion is a very powerful force in markets that can often result in recently poor performing companies to revert back to their mean, offering great potential returns for investors who spot these investments.
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. Another reason the multiple is so high is because due to accounting reasons, Amazon’s earnings are reduced due to their high amounts of capital expenditures and reinvestment into the business. Amazon has been expanding into new markets and has been investing heavily in areas such as cloud computing, artificial intelligence, and logistics, which lowers its current earnings and as a result makes the current P/E look inflated.
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About The Author
Rebecca Hotsko
Rebecca Hotsko is an investor and entrepreneur based in Canada. Most recently, she co-founded a luxury boat sharing club in Kelowna B.C. Rebecca graduated from the University of Saskatchewan with a bachelor’s degree in Economics and since has completed CFA level I and II. In prior years, Rebecca gained valuable experience working as an analyst for the Bank of Canada, the federal energy regulator and in investment management. Her passion for teaching others how to invest using time-tested strategies backed by empirical data also led her to create an investing blog in 2020.
Rebecca Hotsko
Rebecca Hotsko is an investor and entrepreneur based in Canada. Most recently, she co-founded a luxury boat sharing club in Kelowna B.C. Rebecca graduated from the University of Saskatchewan with a bachelor’s degree in Economics and since has completed CFA level I and II. In prior years, Rebecca gained valuable experience working as an analyst for the Bank of Canada, the federal energy regulator and in investment management. Her passion for teaching others how to invest using time-tested strategies backed by empirical data also led her to create an investing blog in 2020.
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