Price-earnings ratio

The price-to-earnings ratio is a fundamental analysis tool that is calculated by dividing the current company stock price by yearly earnings per share. Company analysis​​ looks at financial ratios and accounting statements to determine how a company is performing and whether or not it may be a good investment.

Not only does the ratio look at the earnings, but it compares it to the stock price. The P/E ratio describes how many years of current earnings the shares are priced at. For example, if yearly earnings per share are $1 and the stock price is $48, the stock is priced at 48 years’ worth of current earnings.

In this article, we discuss what is considered to be a high or low ratio, as this also depends on the company’s growth prospects and future potential earnings. A high or low ratio helps traders to assess whether they want to buy, sell, or wait for a better opportunity.

Whereas a normal P/E ratio looks at the most recent year for total earnings, a forward P/E ratio is based on the estimated earnings predicted by analysts for the upcoming year. Both ratios are based on the current stock price.

If forward P/E is lower than normal P/E, this means that analysts are expecting earnings growth in the upcoming year. A drastically lower ratio means that a large amount of growth is expected. On the other hand, if forward P/E is higher than normal P/E, analysts are forecasting lower growth prospects for the company.

P/E ratio = price/earnings

Where:

Price = current share price

Earnings = earnings over past year; total the past four quarterly earnings amounts

Forward P/E ratio = price/forward earnings

Where:

Price = current share price

Forward earnings = expected earnings next year; total the analyst expected earnings for the next four quarters

A business year is not the same as a calendar year; therefore, when calculating past or future earnings, traders and investors often use the prior four quarterly earnings and sum them up to get the total earnings over the past year. Similarly, they could add up the following four quarters of expected earnings to get forward earnings.

Earnings yield is another fundamental analysis ratio. It is the same as P/E but expressed in a different way. Earnings yield is earnings divided by price, expressing earnings for each dollar of price, whereas P/E expresses price for each dollar of earnings.

Let’s look at the technology company Apple Inc. (AAPL)​​ as an example of how to calculate P/E, which is also available for spread betting or CFD trading on our platform. Here are the last four earnings amounts as of February 2021:

The price-to-earnings ratio helps traders to assess how much they are paying for a stock. Traders don’t just look at the raw number; they also look at how the current ratio compares to historical ratios for the stock, how it compares to other companies in the same sector, the overall P/E of a stock market index​​, and the earnings growth potential of the company.

For example, $1 of earnings on a $48 stock may seem expensive at a 48 P/E. But if earnings next year are expected to be $3, then forward P/E is 16. If investor expectations are that earnings could be $10 a few years down the road, paying $48 now may be a good deal. They are paying a 4.8 P/E based on future earnings, should those earnings materialise.

Companies with a high earnings growth rate tend to trade at higher P/E ratios than companies that aren’t growing. This is because people are willing to pay a higher price now if a company is expected to do well in the future. If this is indeed true for the future, the company stock price may be higher to reflect the company’s higher profits.

Companies with lower growth but stable earnings tend to have P/E ratios that fluctuate in a range. Earnings are more stable, so it is the fluctuations in share price over time that primarily cause P/E to fluctuate.

There isn’t a single “good” P/E ratio that guarantees a good purchase, as this will vary between companies, future expectations and overall trading goals. For example, a stock may have a P/E ratio of 1 but, if earnings are dropping every year, the share price could fall along with earnings year after year, all while maintaining the P/E of 1. This is called a “value trap”. The stock looks like a good deal because of the low price-earnings ratio but, as the company’s profits are falling, some wary investors may stay away.

Similarly, a high P/E of 50 may be good value if the company has a high growth rate. If earnings double in the following year, based on the current share price, this is only a 25 P/E ratio, which starts to look more attractive. Investors and institutional money managers are often projecting out multiple years to assess whether a stock is a good purchase now. This is a technique often practised by value investors.

For reference, going back to 1870, the average P/E ratio of major stock indexes have fluctuated between 5 and 25. Since the late 1990s, ratios have tended to be more elevated, typically staying above 15 and reaching over 60 in the stock market crash of 2008 and 2009. In the 2009 case, P/E ratios exploded higher, even though stock prices were dropping and many companies had even faster declines in earnings.

An additional tool that traders can use is price-earnings-to-growth, or the PEG ratio. This is calculated by dividing the P/E ratio by the growth rate of the stock in question. For example, if the P/E is 40 and earnings grew by 30% this year over last year, the PEG ratio would be calculated as: 40/30 = 1.3.

No matter how promising a stock looks, some traders consider using a risk-management strategy​​ such as a stop-loss order on their charts. This helps to exit a trade at a specified level if the price goes against their position.

While the price of a stock can’t go negative, earnings can if the company is losing money. If a stock is priced at $20 but loses $1 per share, it will have a negative P/E ratio of -20. While some financial news sources show negative P/E values, many just put “N/A” or not applicable, since P/E ratios are not especially useful for stocks with negative earnings. A large number of traders choose to avoid trading on shares with negative or non-existent price-earnings ratios, as this could place their trade at a higher risk.

To use P/E ratios when assessing your share trade, you will need to analyse the current share price and earnings amounts. This type of information is available on most financial news sites, as well as in a specific section on our advanced trading platform, Next Generation. After registering for an account, you will have access to our Morningstar equity research reports that provide information for a large number of shares and ETFs. Simply type a company name or ticker symbol into the Product Library window, right-click on it, then select Morningstar Research.

P/E ratios can be useful, and here is a summary of the advantages: