The price-to-earnings ratio (P/E) is one of the most common metrics used by investors to analyze whether investing in a company is a worthwhile endeavor. Simply put, the P/E ratio is the price an investor is willing to pay for each dollar of a company's earnings. The P/E ratio may be calculated with the following mathematical formula:

 P/E Ratio = Price Per Share Earnings Per Share \begin{aligned} \text{P/E Ratio} = \frac{ \text {Price Per Share} }{ \text {Earnings Per Share} } \\ \end{aligned} P/E Ratio=Earnings Per SharePrice Per Share

To cite an example, if a company's stock was trading at $50 per share and had earnings of $5 per share, its P/E ratio would be 10.

Key Takeaways

  • The price-to-earnings ratio is one of the most highly-watched metrics used by investors to analyze whether a company warrants their investment dollars.
  • The P/E ratio is essentially the price an investor is willing to pay for each dollar of a company's earnings.
  • Investors pay extra close attention to the P/E ratios of financial services providers, such as banks, brokerage firms, and insurance companies, because the health of these institutions can broadly indicate the health of the overall economy.

Variations of P/E Ratios

There are several versions of P/E ratios that investors may rely on to gauge a company's fiscal health. These include the following categories:

  • Trailing P/E. This metric uses the weighted average number of common shares that are presently on the open market and divides that figure by the net income from the last 12 months. This is the default P/E ratio if no other type is designated.
  • Trailing P/E from continued operations. This metric relies on operating earnings that do not include earnings from operations that have ceased. It also excludes so-called "extraordinary operations," which define unusual events like accounting changes, write-downs, and one-time windfalls.
  • Forward P/E. Rather than relying on a company's net income, this type of P/E ratio factors in the estimated net earnings for the upcoming 12 months. To cultivate this number, several analysts weigh in with their predictions, and the mean value is then plugged into the formula. 

Average P/E Ratio for the Financial Services Industry

The financial services industry comprises a sizable portion of the U.S. gross domestic product (GDP). For this reason, investors religiously track the P/E ratios of companies within this sector because they broadly indicate the strength of the overall economy. Specifically, investors study the P/E ratios of brokerage firms, banking operations, asset managers, as well as debt and credit service providers.

To cite an actual example, on August 2018, the average P/E ratio of the financial services industry was 14.26. This metric includes the sector averages of specific financial service categories, including banks, which had a P/E ratio of 13.51, capital markets, which had a P/E ratio of 18.83, and the insurance sector, which had a P/E ratio of 14.64. A smaller sector in the broader financial services category, thrifts and mortgage providers, had the highest P/E at 32.17, while the lowest at this time was the mortgage REITs sector at 7.11.