Loading the player...
A:

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.

RELATED FAQS
  1. How do I calculate the P/E ratio of a company?

    Find out how to calculate this common valuation ratio and what the results can tell you about a company's performance. Read Answer >>
  2. What is the average price-to-earnings ratio in the banking sector?

    Explore the price/earnings ratio in regard to the banking industry and learn what the average P/E ratio is for most banking ... Read Answer >>
  3. What does the forward p/e indicate about a company?

    Explore the forward price to earnings ratio and learn its significance and how it compares to the traditional price to earnings ... Read Answer >>
  4. What's the difference between absolute P/E ratio and relative P/E ratio?

    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 ... Read Answer >>
  5. What is the difference between forward p/e and trailing p/e?

    Understand the difference between the trailing P/E ratio, which is the standard price-to-earnings calculation, and the forward ... Read Answer >>
Related Articles
  1. Investing

    Is Stock With a Lower P/E Always A Better Choice?

    Is a stock with a lower P/E always a better investment than a stock with a higher one? The short answer is no, but it depends on a few things.
  2. Investing

    Beware False Signals From The P/E Ratio

    The P/E ratio is a simple tool for evaluating a company, but no one ratio can tell the whole story.
  3. Investing

    Comparing the P/E, EPS And Earnings Yield

    Here are three ratios that help investors value stock returns.
  4. Investing

    Can Investors Trust The P/E Ratio?

    The P/E ratio is one of the most popular stock market ratios, but it has some serious flaws that investors should know about.
  5. Investing

    How Do I Calculate the Price-Earnings Ratio?

    If Apple is trading at $108.73 per share, and its trailing twelve months' EPS is $6.45, calculate the P/E ratio as...
  6. Investing

    The 4 Basic Elements of Stock Value

    Investors use these four measures to determine a stock's worth. Find out how to use them.
RELATED TERMS
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  2. P/E 30 Ratio

    The price-to-earnings (P/E) ratio is the valuation ratio of a ...
  3. Forward Price To Earnings - Forward P/E

    A measure of the price-to-earnings ratio (P/E) using forecasted ...
  4. P/E 10 Ratio

    A valuation measure, generally applied to broad equity indices, ...
  5. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  6. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
Hot Definitions
  1. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  2. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
  3. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household when the actual tax liability is less than the amount ...
  4. Gross Domestic Product - GDP

    The monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
  5. Inflation

    The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of ...
  6. Merchandising

    Merchandising is any act of promoting goods or services for retail sale, including marketing strategies, display design and ...
Trading Center