The short answer? No. The long answer? It depends.

The price-to-earnings ratio (P/E ratio) is calculated as a stock's current share price divided by its earnings per share (EPS) for a twelve-month period (usually the last 12 months, or trailing twelve months (TTM)). Most of the P/E ratios you see for publicly-traded stocks are an expression of the stock's current price compared against its previous twelve months' earnings.

A stock trading at $40/share with an EPS (ttm) of $2 would have a P/E of 20 ($40/$2), as would a stock priced at $20/share with an EPS of $1 ($20/$1). These two stocks have the same price-to-earnings valuation - in both cases investors pay $20 for each dollar of earnings.

But, what if a stock earning $1 per share was trading at $40/share? Now we'd have a P/E ratio of 40 instead of 20, which means the investor would be paying $40 to claim a mere $1 of earnings. This seems like a bad deal, but there are several factors which could mitigate this apparent overpricing problem.

First, the company could be expected to grow revenue and earnings much more quickly in the future than companies with a P/E of 20, thus commanding a higher price today for the higher future earnings. Second, suppose the estimated (trailing) earnings of the 40-P/E company are very certain to materialize, whereas the 20-P/E company's future earnings are somewhat uncertain, indicating a higher investment risk. Investors would incur less risk by investing in more certain earnings instead of less certain ones, so the company producing those sure-thing earnings again commands a higher price today.

Secondly, it must also be noted that average P/E ratios tend to vary from industry to industry. Typically, P/E ratios of companies in very stable, mature industries which have more moderate growth potential have lower P/E ratios than companies in relatively young, quick-growing industries with more robust future potential. Thus, when an investor is comparing P/E ratios from two companies as potential investments, it is important to compare companies from the same industry with similar characteristics. Otherwise, if an investor simply purchased stocks with the lowest P/E ratios, they would likely end up with a portfolio full of utilities stocks and similar companies, which would leave them poorly diversified and exposed to more risk than if they had diversified into other industries with higher-than-average P/E ratios. (To read more on P/E ratios, see Understanding The P/E Ratio and Analyze Investments Quickly With Ratios.)

However, this doesn't mean that stocks with high P/E ratios cannot turn out to be good investments. Suppose the same company mentioned earlier with a 40-P/E ratio (stock at $40, earned $1/share last year) was widely expected to earn $4/share in the coming year. This would mean (if the stock price didn't change) the company would have a P/E ratio of only 10 in one year's time ($40/$4), making it appear very inexpensive.

The important thing to remember when looking at P/E ratios as part of your stock analysis is to consider what premium you are paying for a company's earnings today, and determine if the expected growth warrants the premium. Also compare it to its industry peers to see its relative valuation to determine whether the premium is the worth the cost of the investment.

Now that you have an understanding of the P/E ratio in terms of stock valuation, learn how the PEG Ratio can help investors price a company based on its future growth potential in

Move Over P/E, Make Way For The PEG.

  1. Have hedge funds eroded market opportunities?

    Hedge funds have not eroded market opportunities for longer-term investors. Many investors incorrectly assume they cannot ... Read Full Answer >>
  2. 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 >>
  3. 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 >>
  4. 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 >>
  5. What is the average price-to-book ratio of companies in the retail sector?

    The retail sector includes seven types of retail companies: automotive; building supply; distributors; general; grocery and ... Read Full Answer >>
  6. What metrics are commonly used to evaluate companies in the retail sector?

    Some of the most commonly used metrics to evaluate companies in the retail sector include the price/earnings to growth (PEG) ... Read Full Answer >>
Related Articles
  1. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  2. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  3. Chart Advisor

    Low P/E Stocks Ready for a Turnaround?

    These stocks appear to be of great value based on P/E and Forward P/E.
  4. Investing Basics

    The Best Litmus Test Of A Company's Risk? The Acid Test

    The acid test measures a company’s short-term liquidity.
  5. Stock Analysis

    Is Qualcomm Stock Suitable for Your IRA or Roth IRA?

    Find out if Qualcomm stock is an appropriate retirement investment based on stability and valuation. Is QCOM more suitable for a traditional IRA or Roth IRA?
  6. Investing Basics

    Is Warren Buffet's Investment Strategy Suitable for Your Financial Profile?

    Learn about how investors may not be able to replicate Warren Buffett's value investing strategy. See how they can still easily follow Buffett's sage advice.
  7. Stock Analysis

    Should You Buy Apple Stock Right Now? Here's How to Decide

    Find out how to analyze Apple stock. What factors should investors consider? Learn how to determine how much Apple shares are worth.
  8. Mutual Funds & ETFs

    Want ETFs But Hate To Buy And Hold? Try Active ETFs

    Choosing between passive and active ETFs depends on your beliefs about active management's value.
  9. Stock Analysis

    Berkshire Hathaway's 4 Key Financial Ratios

    Read about the key financial ratios to analyze Berkshire Hathaway. Understand why Buffett likes companies with low debt/equity ratios.
  10. Investing Basics

    What Is The Intrinsic Value Of A Stock?

    Intrinsic value can be subjective and difficult to estimate. It’s a perception of a security’s value that factors tangible and intangible factors.
  1. Discounted Cash Flow (DCF)

    Discounted cash flow (DCF) is a valuation method used to estimate ...
  2. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  3. Warren Buffett

    Known as "the Oracle of Omaha", Buffett is Chairman of Berkshire ...
  4. Return On Equity - ROE

    The amount of net income returned as a percentage of shareholders ...
  5. Cash Flow-to-Debt Ratio

    A ratio of a company’s cash flow from operations to its total ...
  6. P/E 10 Ratio

    A valuation measure, generally applied to broad equity indices, ...

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center