The price-to-earnings ratio or P/E is one of the most widely-used stock analysis tools used by investors and analysts for determining stock valuation. In addition to showing whether a company's stock price is overvalued or undervalued, the P/E can reveal how a stock's valuation compares to its industry group or a benchmark like 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.
Components Of The P/E Ratio
Market Price
- 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 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 which earnings variant is used.
- Typically, EPS is taken from the last four quarters called trailing EPS and is commonly referred to as TTM for trailing twelve months. However, EPS can also be 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 19xs earnings. However, the 18.92 P/E by itself isn't very helpful unless you have something to compare it to. A common comparison could be to 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 15xs earnings.
To compare Bank of America's P/E to a peer bank, let's 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 BofA's P/E of almost 19 to JPMorgan's P/E of 17, Bank of America's stock doesn't appear as overvalued as it did when compared to 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, please use a variety of financial ratios to determine whether a stock is fairly valued and whether a company's financial health justifies its stock's valuation.
For more on the P/E ratio, how to use it, and its potential the flaws, please read P/E Ratio: What Is It?
-
What does it mean if a bond has a zero coupon rate?
Learn what the average range for the price to earnings (P/E) ratio in the electronics sector is and which factors influence ... Read Answer >> -
What is the average price-to-earnings ratio in the oil & gas drilling sector?
Investing in the energy sector provides an opportunity for value investors, but it is necessary to understand metrics such ... Read Answer >> -
Absolute P/E Ratio Vs. Relative P/E Ratio
The difference between absolute P/E and relative P/E is easier when you know why each term is used. Read Answer >> -
What is the average price-to-earnings ratio in the financial services sector?
Learn how to calculate and use the price to earnings (P/E) ratio when analyzing an investment and what the financial services ... Read Answer >> -
How do companies benefit from price discrimination?
Learn what the average price-to-earnings ratio is for the insurance sector and why the average price-to-earnings ratio should ... Read Answer >> -
What is the average price-to-earnings ratio in the automotive sector?
Learn the average price-to-earnings ratio for the automotive sector and how it is used to evaluate a company’s potential ... Read Answer >>
-
Investing
Comparing the P/E, EPS And Earnings Yield
Here are three ratios that help investors value stock returns. -
Investing
Getting On The Right Side Of The P/E Ratio Trend
Buying at the right time is crucial, but how do we know when that is? -
Investing
Are Stocks with Low P/E Ratios Always Better?
Is a stock with a lower P/E ratio always a better investment than a stock with a higher one? The short answer is no. The long answer is it depends. -
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. -
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. -
Investing
5 Must-Have Metrics for Value Investors
These quick-and-dirty ratios will help you find the most undervalued stocks on the market.
-
Forward Price To Earnings - Forward P/E
A measure of the price-to-earnings ratio (P/E) using forecasted ... -
Trailing Price-To-Earnings - Trailing P/E
The sum of a company's price-to-earnings, calculated by taking ... -
Price/Earnings To Growth - PEG Ratio
Price/Earnings to Growth (PEG) is a stock's price to earnings ... -
Current Ratio
The current ratio is a liquidity ratio that measures a company's ... -
Price Multiple
A price multiple is any ratio that uses the share price of a ... -
Rule Of 18
A rule whereby the sum of the inflation rate and the P/E ratio ...