The price-to-earnings ratio (P/E) is one of the most widely-used tools that investors and analysts use to determine a stock's valuation. The P/E ratio is one indicator of whether a stock is overvalued or undervalued. Also, a company's P/E can be benchmarked against other stocks in the same industry or the S&P 500 Index.

The P/E ratio measures the market value of a stock compared to the company's earnings. The P/E ratio reflects what the market is willing to pay today for a stock based on its past or future earnings. However, the P/E ratio can mislead investors, because past earnings do not guarantee future earnings will be the same. Likewise, projected earnings may not come to fruition.

Key Takeaways

  • The price-to-earnings (P/E) ratio measures a company's market price compared to its earnings. It shows what the market is willing to pay today for a stock based on a company's past or future earnings.
  • A company's P/E ratio can be benchmarked against other stocks in the same industry or the S&P 500 Index.
  • This helps show whether a stock is overvalued or undervalued.
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The Price To Earnings Ratio Explained

Components of P/E Ratio

Market Price

  • The prevailing market price of a stock represents the "P" in P/E ratio. 
  • Stock price is determined by supply and demand in the market. 

Earnings per Share

  • Earnings per share (EPS) is the amount of profit allocated to each share of a company's common stock. EPS is the portion of net income that would be earned per share if all profits were distributed to shareholders. Analysts and investors use EPS to establish a company's financial strength.
  • EPS represents the "E" in P/E ratio, where EPS = earnings ÷ total shares outstanding.
  • As long as a company has positive earnings, the P/E ratio can be calculated. A company that is losing money has no P/E ratio.
  • EPS is often taken from a company's last four quarters of financial results, or the trailing 12 months (TTM), and is called the trailing EPS. However, EPS can also be taken from future earnings forecast over the coming four quarters, which is called the forward EPS.

As a result, a company will have more than one P/E ratio, and investors must be careful to compare the same P/E when evaluating and comparing different stocks.

No single ratio will tell an investor everything they need to know about a stock. Investors should use a variety of financial ratios to assess the value of a stock.

Calculating P/E Ratio

To calculate a company’s P/E ratio, we use the following formula:

P/E Ratio=Price per ShareEarnings per Share\text{P/E Ratio}=\frac{\text{Price per Share}}{\text{Earnings per Share}}P/E Ratio=Earnings per SharePrice per Share

Example of P/E Ratio: Comparing Bank of America and JPMorgan Chase 

Bank of America Corporation (BAC) closed 2017 with the following:

  • Stock Price = $29.52
  • Diluted EPS = $1.56
  • P/E = 18.92 or $29.52 ÷ $1.56

In other words, Bank of America traded at roughly 19x trailing earnings. However, the 18.92 P/E multiple by itself isn't helpful unless you have something to compare it with, such as the stock's industry group, a benchmark index, or Bank of America's historical P/E range.

Bank of America's P/E at 19x was slightly higher than the S&P 500, which over time trades at about 15x trailing earnings. 

To compare Bank of America's P/E to a peer, we calculate the P/E for JPMorgan Chase & Co. (JPM) as of the end of 2017.

  • Stock Price = $106.94
  • Diluted EPS = $6.31
  • P/E = 16.94

When you compare Bank of America's P/E of almost 19x to JPMorgan's P/E of roughly 17x, Bank of America stock does not appear as overvalued as it did when compared with the average P/E of 15 for the S&P 500. Bank of America's higher P/E ratio might mean investors expected higher earnings growth in the future compared to JPMorgan and the overall market.

However, no single ratio can tell you all you need to know about a stock. Before investing, it is wise to use a variety of financial ratios to determine whether a stock is fairly valued and whether a company's financial health justifies its stock valuation.