The P/E ratio (or "P/E") is the most common and widely used of valuation metrics. Virtually every financial website displays it and it is commonly used as a jumping off point for valuation discussions.
The P/E is a quick way to look at the valuation of a stock. One way to view it is as how many years it would take for you to recover your investment principal from the earnings a company generates, assuming no change in those earnings. For example, if you were to buy a company for $5 million that had annual net income of $1 million -- a P/E of 5 -- it would take you 5 years to break even on that investment.
Flavors of P/E
This is the most commonly discussed P/E. Unless stated otherwise, you can probably assume that a displayed P/E is a trailing P/E. This is the one shown on sites such as Yahoo! Finance.
It is the current stock price divided by the earnings per share (EPS) from the last four reported quarters. To calculate it, go to a site such as Yahoo! Finance or Google Finance, look at the income statement summary pages, set the view to quarterly, and add up the EPS from the last four quarters. Then divide that total into the current stock price.
For example, if the company earned $0.37, $0.42, $0.26, and $0.22 in EPS over the last four quarters and the stock price was $17.33, then the P/E would be $17.33 / $1.27 = 13.64. When the next quarter is reported, the oldest quarter's number is dropped so that the EPS used is always the four most recent quarters.
A critique of using trailing earnings as a source of valuation guidance is that they aren't necessarily predictive of future earnings. For example, if a company's P/E clocks in at a seemingly low 5.5, but those trailing earnings were courtesy of a cyclical peak, that 5.5 figure is overstating the company's normalized earnings power.
The least commonly referenced of the three versions of the P/E ratio, this is the stock price divided by the consensus analysts' estimates for earnings in the current fiscal year. These are usually updated as the company reports earnings through the year, but actual company reported earnings are not used to calculate this.
To determine this one, go to a site such as Yahoo! or Google Finance or Morningstar, find the page which shows analyst expectations and look for the current year estimate of earnings. Divide that into the share price to get the current P/E.
This is the stock price divided by the consensus expected earnings for the next year, as opposed to the current or trailing year. The same procedure is used to calculate this ratio, but use the estimated earnings for next year, not this year.
A risk with using the forward P/E ratio is that, assuming earnings are expected to grow, it can be used to paint a somewhat rosier picture of a valuation than might otherwise be thought. Not surprisingly, analysts, investors, and companies advocating a growth stock tend to gravitate towards using forward P/E's as they tend to portray valuations in a more favorable light. Another consideration worth noting is that ratio is based on analysts' expected results which may turn out to be aggressive.
The P/E is sometimes referred to as an *Investor Sentiment* indicator. The P/E will move minute by minute as the price changes, as earnings changes usually happen only once a quarter. As the P/E goes up, it shows that current investor sentiment is that the company is worth more, its future prospects are bright, and sellers are only giving up their stock at higher prices. A dropping P/E is an indication that the company is out of favor with investors.
The median stock in the S&P 500 Index has historically had a P/E ratio of about 15. A lower P/E ratio likely implies a company is in its mature stage or has cyclical, inconsistent earnings. A very low P/E implies that investors believe earnings are likely to decline in the future. High growth companies can justify higher P/Es, but P/Es over 30 are difficult to sustain with earnings growth. They are considered speculative. Similarly, companies with no or negative earnings have non-applicable P/E's, forcing those relying on using a multiple to lean on either price-to-book ratios or price-to-sales. Companies posting losses are frequently new companies or start-ups, oftentimes with excellent prospects, but not yet earning a profit.
P/E should never be used alone in valuing a company because earnings are fluid and can change due to a variety of circumstances. A company with a P/E of 5 is not necessarily a better investment than a company with a P/E of 30. Sometimes there are good reasons for a P/E to be low or high. The trick to investing wisely is knowing when the market has it right and when it does not.
P/E is most useful in comparing one investment to another. Just as a median S&P 500 company tends to have a P/E of 15, other industries and sectors of the economy have their own norms. A close competitor should have a similar P/E. If it does not, that can signal an investment opportunity, or at least a subject for closer research. As companies used in the comparison become less similar, the P/E comparison increases in risk.
Discuss this article on the P/E ratio board.
David Gardner Explains