1. P/E Ratio: An In-Depth Guide
  2. P/E Ratio: What Is It?
  3. P/E Ratio: Using The P/E Ratio
  4. P/E Ratio: Problems With The P/E
  5. P/E Ratio: It's Not A Crystal Ball
  6. P/E Ratio: Conclusion

Theoretically, a stock's P/E tells us how much investors are willing to pay per dollar of earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay $20 for every $1 of earnings that the company generates. However, this is a far too simplistic way of viewing the P/E because it fails to take into account the company's growth prospects.

Growth of Earnings
Although the EPS figure in the P/E is usually based on earnings from the last four quarters, the P/E is more than a measure of a company's past performance. It also takes into account market expectations for a company's growth. Remember, stock prices reflect what investors think a company will be worth. Future growth is already accounted for in the stock price. As a result, a better way of interpreting the P/E ratio is as a reflection of the market's optimism concerning a company's growth prospects.

If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop.

A good example is Microsoft. Several years ago, when it was growing by leaps and bounds, and its P/E ratio was over 100. Today, Microsoft is one of the largest companies in the world, so its revenues and earnings can't maintain the same growth as before. As a result, its P/E had dropped to 43 by June 2002. This reduction in the P/E ratio is a common occurrence as high-growth startups solidify their reputations and turn into blue chips.

Cheap or Expensive?
The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things being equal, a $10 stock with a P/E of 75 is much more "expensive" than a $100 stock with a P/E of 20. That being said, there are limits to this form of analysis - you can't just compare the P/Es of two different companies to determine which is a better value.

It's difficult to determine whether a particular P/E is high or low without taking into account two main factors:

1. Company growth rates
- How fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? Something isn't right if a company has only grown at 5% in the past and still has a stratospheric P/E. If projected growth rates don't justify the P/E, then a stock might be overpriced. In this situation, all you have to do is calculate the P/E using projected EPS.

2. Industry - It is only useful to compare companies if they are in the same industry. For example, utilities typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterized by phenomenal growth rates and constant change. Comparing a tech company to a utility is useless. You should only compare high-growth companies to others in the same industry, or to the industry average. You can find P/E ratios by industry on Yahoo! Finance.

P/E Ratio: Problems With The P/E

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

    Differences Between Forward P/E And Trailing P/E

    The most common types of price to earnings ratios are forward P/E and trailing P/E. Find out how they differ and the advantages and drawbacks of each.
  4. Investing

    Comparing the P/E, EPS And Earnings Yield

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

    Explaining Forward Price-to-Earnings Ratio

    The estimated P/E of a company is often used to compare current earnings to estimated future earnings.
  6. 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...
  7. Investing

    How To Use The P/E Ratio And PEG To Tell A Stock's Future

    While the price-to-earnings ratio is commonly used for assessing stock prices, the price/earnings-to-growth ratio offers forecasting advantages that investors need to know.
  8. Investing

    Profit With The Power Of P/E Ratio

    The P/E ratio is a valuable tool when deciding on an investment, but it's not the only thing to consider.
  9. 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.
  10. Investing

    Comparing The P/E, EPS And Earnings Yield

    P/E may be the established standard for valuation purposes, but the earnings yield is especially useful for comparing potential returns across different instruments.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center