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. 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 >>
  2. 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 >>
  3. 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 >>
  4. 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 >>
  5. 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 >>
  6. Are companies with high Book Value Of Equity Per Share (BVPS) takeover targets?

    Companies with high book value of equity per share (BVPS) can be good takeover targets if those companies are public and ... Read Full Answer >>
Related Articles
  1. Investing

    A Look at 6 Leading Female Value Investors

    In an industry still largely predominated by men, we look at 6 leading female value investors working today.
  2. Fundamental Analysis

    Value Investing Strategies in a Volatile Market

    Volatile markets are a scary time for uneducated investors, but value investors use volatile periods as an opportunity to buy stocks at a discount.
  3. Mutual Funds & ETFs

    3 Strategies for Trading Mutual Funds

    Learn some of the most commonly used investment strategies employed by mutual fund managers or that can be employed by individual mutual fund investors.
  4. Stock Analysis

    Coca-Cola Vs. PepsiCo: Which Stock Should You Buy?

    Learn about the bull case for Coca-Cola and PepsiCo. Find out which is more attractive for investors, and learn about the strengths of each company.
  5. Stock Analysis

    Is Texas Instruments a Good Value Play?

    Find out whether investors and analysts believe that Texas Instruments would make a good value play at its current valuation, and learn more about its outlook.
  6. Investing

    2 Sectors to Explore When Rates Rise

    While the market selloff and declining inflation expectations have lowered the probability of a Fed rate rise, U.S. economic data still supports it.
  7. Insurance

    Warren Buffett: The Road To Riches

    Find out how he went from selling soft drinks to buying up companies and making billions of dollars.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares S&P Small-Cap 600 Value

    Learn how the iShares S&P Small-Cap 600 Value exchange-traded fund is managed, which benchmark it tracks and for whom it is most appropriate.
  9. 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.
  10. 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.
  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. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
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!