A:

The simple answer to this question is that absolute P/E, which is the most quoted of the two ratios, is the price of a stock divided by the company's earnings per share (EPS). This measure indicates how much investors are willing to pay per dollar of earnings. The relative P/E ratio, on the other hand, is a measure that compares the current P/E ratio to the past P/E ratios of the company or to the current P/E ratio of a benchmark. Let's look at both absolute and relative P/E in more detail.

Absolute P/E The nominator of this ratio is usually the current stock price, and the denominator may be the trailing EPS (from the trailing 12 months [TTM]), the estimated EPS for the next 12 months (forward P/E) or a mix of the trailing EPS of the last two quarters and the forward P/E for the next two quarters. When distinguishing absolute P/E from relative P/E, it is important to remember that absolute P/E represents the P/E of the current time period.
For example, if the price of the stock today is $100, and the TTM earnings are $2 per share, the P/E is 50 ($100/$2).

Relative P/E Relative P/E compares the current absolute P/E to a benchmark or a range of past P/Es over a relevant time period, such as the last 10 years. Relative P/E shows what portion or percentage of the past P/Es the current P/E has reached. Relative P/E usually compares the current P/E value to the highest value of the range, but investors might also compare the current P/E to the bottom side of the range, measuring how close the current P/E is to the historic low. The relative P/E will have a value below 100% if the current P/E is lower than the past value (whether the past high or low). If the relative P/E measure is 100% or more, this tells investors that the current P/E has reached or surpassed the past value.

Suppose a company's P/Es over the last 10 years have ranged between 15 and 40. If the current P/E ratio is 25, the relative P/E comparing the current P/E to the highest value of this past range is 0.625 (25/40), and the current P/E relative to the low end of the range is 1.67 (25/15). These value tell investors that the company's P/E is currently 62.5% of the 10-year high, and 67% higher than the 10-year low.

If all is equal over the time period, the closer the P/E gets to the high side of the range and further away from the low side, the more caution an investor needs since this could mean the stock is overvalued. There is, however, a lot of discretion that goes into interpreting relative P/E. Fundamental shifts in the company such as an acquisition of a highly profitable entity can justifiably increase the P/E above the historic high.

As we mentioned above, relative P/E may also compare the current P/E to the average P/E of a benchmark such as the S&P 500. Continuing with the example above where we have a current P/E ratio of 25, suppose the P/E of the market is 20. The relative P/E of the company to the index is therefore 1.25 (25/20). This shows investors that the company has a higher P/E relative to the index, indicating that the company's earnings are more expensive than that of the index. A higher P/E, however, does not mean it is a bad investment. On the contrary, it may mean the company's earnings are growing faster than those represented by the index. If, however, there is a large discrepancy between the P/E of the company and the P/E of the index, investors may want to do additional research into the discrepancy.
Conclusion
Absolute P/E, compared to relative P/E, is the most-often used measure and is useful in investment decision making; however, it is often wise to expand the application of that measure with the relative P/E measure to gain further information.

For more information on the price to earnings ratio please read Understanding the P/E Ratio tutorial.

RELATED FAQS
  1. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  2. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
  3. How can EV/EBITDA be used in conjunction with the P/E ratio?

    Because they provide different perspectives of analysis, the EV/EBITDA multiple and the P/E ratio can be used together to ... Read Full Answer >>
  4. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  5. What is the average return on equity for a company in the retail sector?

    The retail sector includes automotive; building supply; distributors; general; grocery and food; online; and special lines ... Read Full Answer >>
  6. What is the average price-to-earnings ratio in the retail sector?

    According to NYU's Stern School of Business, as of January 2015, using trailing 12-month data, the average price-to-earnings ... Read Full Answer >>
Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB Commodity Tracking

    Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.
  2. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  3. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Value

    Find out about the Vanguard Small-Cap Value ETF, and explore detailed analysis of its characteristics, suitability, recommendations and historical statistics.
  4. Investing Basics

    Understanding the Spot Market

    A spot market is a market where a commodity or security is bought or sold and then delivered immediately.
  5. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Insurance

    Learn about the SPDR S&P Insurance exchange-traded fund, which follows the S&P Insurance Select Industry Index by investing in equities of U.S. insurers.
  6. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  7. Chart Advisor

    Value Stocks Offer Stability in a Volatile Market

    With volatility on the rise, investors are turning to segments of strength such as value stocks. We'll take a look at several ETFs that could be worth a closer look.
  8. Stock Analysis

    3 Reasons to Short Monster Beverage

    Learn why, despite the popular perception of Monster Beverage as a high-growth stock, investors may be better off taking a short position on it.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares S&P Mid-Cap 400 Value

    Understand how the iShares S&P Mid-Cap 400 Value exchange-traded fund presents an opportunity for investors to diversify a portfolio with mid-cap securities.
  10. Investing

    Finding Value in the Selloff Rubble

    Globally and in the United States, stocks are now in correction mode, with the recent erosion in equities in emerging markets and Europe in a bear market.
RELATED TERMS
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Derivative

    A security with a price that is dependent upon or derived from ...
  4. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  5. Inverse Transaction

    A transaction that can cancel out a forward contract that has ...
  6. Best To Deliver

    The security that is delivered by the short position holder in ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!