What Is a P/E Ratio?
The price-to-earnings (P/E) ratio is one of the most frequently used and trusted stock valuation metrics. The P/E ratio measures a company's current stock price compared to its earnings per share (EPS). It is calculated by dividing a company's share price by its earnings per share. This provides a measure of the price being paid for the earnings.
Investors and analysts can use a company's P/E ratio to compare the performance of two similar companies. As such, it provides individuals with an apples-to-apples comparison. Keep in mind, though, that using a company's P/E ratio alone doesn't provides a full picture of the price of its stock. This means it's important to look at it relative to the company's industry or a broad market index, such as the Dow Jones Industrial Average (DJIA) or S&P 500.
- A P/E ratio is a valuation method that measures a company's stock price compared to its earnings per share.
- Individual company P/E ratios are often listed on many financial websites but that isn't always true for market indexes.
- Experts recommend that, in order to get an accurate P/E reading, analysts and investors go to the index publisher's website.
- To calculate the P/E index of a market index, add all the share prices of the companies listed and divide that by the sum of their earnings per share.
- You may also use an ETF that tracks a market index to get an estimate of its P/E ratio.
Dow Jones & S&P 500 P/E Ratios
Many financial websites have P/E ratios for individual companies. But if you try to find most of them don't include these ratios for indexes like the S&P 500 or the Dow Jones Industrial Average and they may not even be accurate. That's because some calculations or listings of an index's P/E ratio do not include companies in the index with negative earnings while others fail to factor in the weighting of the index.
The accurate P/E ratio of an index can sometimes be difficult to obtain. To get an accurate P/E reading, analysts and investors typically need to go to the index publisher's website. Or you can try to calculate it yourself.
As of Jan. 19, 2023, the P/E ratio for the Dow was 21.91. The S&P 500's P/E ratio was 19.15 as of Jan. 13, 2023.
Calculating Index P/E Ratios
When you want to find the P/E ratio for a company, you can either locate it on a financial website or by calculating it yourself. You can do this by using this formula:
P/E Ratio = Stock Price ÷ Annual EPS
So if a company's stock price is $15 and its annual EPS is $2, its P/E ratio would be $15 ÷ $2 or 7.5.
You can use the same principle to determine the P/E ratio of a market index like the DJIA and the S&P 500. But you'll have to do a little more searching and math to get the result. Here's how: Locate the stock price of every company listed on the index in question and add them up. Then add up all of their annual EPS. Divide the total of all the share prices by the sum of all the EPS.
Index P/E Ratio = Sum of Share Prices ÷ Sum of Index Participants' EPS
So if there are 10 companies in an index whose share prices add up to $150 and the total value of their EPS is $10, then the index's P/E ratio would be $15.
A high P/E ratio signifies greater investor confidence in a company's future prospects, but it can also be a sign that shares are overvalued.
Since this can be a time-consuming process, some investors prefer to accept the approximation provided by the P/E ratio of an exchange-traded fund (ETF) that closely tracks a related index. While this measure is not as exact as the index's own measure, the information is a lot easier to find. For example, those who want to know the P/E ratio of the S&P 500 can look at the SPDR S&P 500 ETF (SPY) and the SPDR Dow Jones Industrial Average ETF (DIA) for the Dow.
As noted, there may be some discrepancy between an ETF's P/E ratio and that of the index itself. This difference may be due to the fees charged on an ETF, not to mention the fact that ETFs are traded on the stock market. Fluctuations in the price of the ETF are affected by both the underlying index and the regular price movement of the ETF, which acts like a stock.
Another variation can result from the fact that the ETF's holdings may not precisely match the index's equity makeup. That said, the return on an ETF is often very close to that of the index, and an ETF's P/E ratio often provides a good approximation for the P/E of the index it tracks.
The Bottom Line
A company's P/E ratio can be a great tool to make important decisions about your current and future investments. One of the things you can gauge with this metric is whether a stock is under or overvalued compared to its earnings. This information can be easily obtained from a variety of financial websites.
But that isn't always the case if you're looking at market indexes as an investment. If you want to figure out the P/E ratio of an index like the Dow or the S&P 500, you'll have to do a little homework and find out the individual share prices and earnings per share for each company listed, then use the formula above. That can be a lot of work but there is a workaround. Look for an ETF that tracks the index. Keep in mind the ETF's P/E ratio may be skewed because of fees and other factors.
Correction—Jan. 20, 2023: This article has been edited from a previous version that incorrectly explained how investors calculate the P/E ratio of an index. The correct way to determine an index's P/E ratio is by adding the sum of the share prices of the companies listed and dividing that figure by the sum of their earnings per share.