Each of these metrics takes a similar approach to P/E in determining a good value stock vs an expensive stock. Simply replace the EPS calculation on the bottom of the equation with the company’s sales or free cash flow. “The P/E ratio tells how much an investor is willing to pay for $1 of earnings of the underlying company,” says Andrew Crowell, a financial advisor and vice chairman of Wealth Management at D.A. An advantage of using the PEG ratio is that you can compare the relative valuations of different industries that may have very different prevailing P/E ratios. This facilitates the comparison of different industries that each tends to have its own historical P/E range. A P/E ratio of 20 means that a stock is trading at 20 times the company’s annual profits.
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That is, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E ratio could signal that a stock’s price is high relative to earnings and is overvalued. Conversely, a low P/E could indicate that the stock price is low relative to earnings. The price-to-earnings (P/E) ratio measures a company’s share price relative to its earnings per share (EPS). Often called the price or earnings multiple, the P/E ratio helps assess the relative value of a company’s stock. It’s handy for comparing a company’s valuation against its historical performance, against other firms within its industry, or the overall market.
Types of P/E Ratios
Forward P/E is usually calculated by dividing the current share price by the estimated following fiscal or calendar year of EPS. This can be useful because past performance doesn’t always predict future results with great accuracy. The price-to-earnings ratio, also referred to as the price-earnings multiple, describes how much money a company is making compared to the price of its stock. It is a common metric used to help discern a company’s value at its current share price.
Earnings Makeup of a Company
It assesses a company’s valuation relative to its earnings before interest, taxes, depreciation, and amortization. The EV/EBITDA ratio is helpful because it accounts for the company’s debt and cash levels, providing a more holistic view of its valuation compared to the P/E ratio. Investors often use the EV/EBITDA ratio to evaluate companies in capital-intensive industries such as telecommunications or utilities.
P/E ratio investing strategies
- While the P/E ratio is frequently used to measure a company’s value, its ability to predict future returns is a matter of debate.
- A low PE ratio may signal that the stock price doesn’t accurately reflect the true value of the company based on its earnings.
- The level of debt in a company has an influence on the P/E ratio because it affects both earnings and share price.
- The price-to-earnings, or P/E, ratio is one of the most common financial ratios used by investors to evaluate stocks.
At the same time, the predictions of future growth are only estimates and could very well be flawed. If a company doesn’t grow and its earnings stay flat, the P/E ratio can also be interpreted as the number of years it’ll likely take before it pays back the amount paid per share. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The P/E ratio would be a significantly large multiple and not be comparable to industry peers (i.e. as a complete outlier) — or even come out to be a negative number.
Companies that grow faster than average, such as technology companies, typically have higher P/Es. A higher P/E ratio shows that investors are willing to pay a higher share price now due to growth expectations in the future. An investor can find the company’s current share price by looking up the stock’s ticker symbol on any search engine or financial website. For example, if a company has earnings of $10 billion and has 2 billion shares outstanding, its EPS is $5. If its stock price is currently $120, its PE ratio would be 120 divided by 5, which comes out to 24. One way to put it is that the stock is trading 24 times higher than the company’s earnings, or 24x.
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In addition to indicating whether a company’s stock price is overvalued or undervalued, the P/E ratio can reveal how a stock’s value compares with its industry or a benchmark like the S&P 500. Investors often base their purchases on potential earnings, not historical performance. Using the trailing P/E ratio can be a problem because it relies on a fixed earnings per share (EPS) figure, while stock prices are constantly changing. This means that if something significant affects a company’s stock price, either positively or negatively, the trailing P/E ratio won’t accurately reflect it.
But consumer cyclical stocks often have higher earnings because consumers may be more willing to purchase on credit when rates are low. Banks earn more income as interest rates rise because they can charge higher rates on their credit products, such as credit cards and mortgages. Basic materials and energy companies also receive a boost in earnings from inflation because they can charge higher prices for the commodities they harvest.
Trailing 12 months (TTM) represents the company’s performance over the past 12 months. These different versions of EPS form the basis of trailing and forward P/E, respectively. P/E Ratio, or the Price-to-Earnings ratio, is a metric measuring the price of a stock relative to its earnings per share (EPS). Trailing P/E ratios are derived from the earnings per share of a stock over the last 12 months, rather than future projections.
Some analysts believe that stocks with relatively low P/E ratios present buying opportunities, allowing investors to purchase an undervalued stock that still has strong earnings. Investors seeking out these value investments expect a potential for share price growth. The PEG (price/earnings growth) ratio takes into account not only a stock’s P/E ratio but also its expected earnings growth. PEG can give investors a more comprehensive take on a stock’s potential and whether it’s undervalued or overvalued compared to companies in the same industry with similar growth prospects. A high P/E ratio signals that a company’s stock price is high relative to its earnings. But if the company cannot keep up with growth expectations, the stock may be viewed as overvalued and see a reversal in price, as investors lose confidence.
