The price-to-earnings ratio or P/E is one of the most widely-used stock analysis tools used by investors and analysts to determine a stock's valuation. The P/E shows whether a company's stock price is overvalued or undervalued. Also, the P/E can be benchmarked with other stocks in the same industry or the S&P 500 Index.
The P/E ratio helps investors determine the market value of a stock as compared to the company's earnings. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings.
The Price To Earnings Ratio Explained
Components of the P/E Ratio
- The prevailing market price of a stock is typically used for the P/E ratio.
- The stock price per share is set by the supply and demand in the prevailing market.
Earnings per Share
- Earnings per share is the amount of a company's profit allocated to each outstanding share of a company's common stock serving as an indicator of the company’s financial health. In other words, earnings per share is the portion of a company's net income that would be earned per share if all the profits were paid out to its shareholders. EPS is typically used by analysts and traders to establish the financial strength of a company.
- EPS provides the “E” or earnings portion of the P/E (price-earnings) valuation ratio where EPS = earnings ÷ total shares outstanding.
- As long as a company has positive earnings, the P/E ratio can be calculated. A company with no earnings, or one that is losing money, has no P/E ratio.
- Similar to the stock price, the earnings per share value will vary depending on the company’s financials and the earnings variant used.
- Typically, EPS is taken from the last four quarters, called the trailing EPS, and is commonly referred to as TTM for the trailing twelve months. However, EPS is also taken from the estimates of future earnings expected over the next four quarters called 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.
Calculating the P/E Ratio
To calculate a company’s P/E ratio, we use the following formula:
Example of P/E Ratio: Comparing Bank of America and JPMorgan Chase
As of the end of 2017, Bank of America Corporation (BAC) closed the year with the following:
- Stock Price = $29.52
- EPS = $1.56
- P/E = 18.92 or $29.52/$1.56
In other words, Bank of America was trading at roughly 19x earnings. However, the 18.92 P/E by itself isn't particularly helpful unless you have something to compare it to. A common comparison would be against the stock's industry group, a benchmark index, or the historical P/E range of a stock.
Bank of America's P/E was slightly higher than the S&P 500, which typically averages around 15x earnings.
To compare Bank of America's P/E to a peer bank, we calculate the P/E for JPMorgan Chase & Co. (JPM) as of the end of 2017.
- Stock Price = $106.94
- EPS = $6.31
- P/E = 17.00
When you compare Bank of America's P/E of almost 19 to JPMorgan's P/E of 17, Bank of America's 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 that investors expect 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.