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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. A high P/E could mean that a stock's price is high relative to earnings and possibly overvalued. Conversely, a low P/E might indicate that the current stock price is low relative to earnings. 

However, companies that grow faster than average typically have higher P/Es like technology companies, for example. A higher P/E ratio shows that investors are willing to pay a higher share price today because of growth expectations in the future. The average P/E for the S&P 500 has ranged from 13 to 15 historically. So a company with a current P/E of 25, above the S&P average, trades at 25 times earnings. The high multiple indicates that investors expect higher growth from the company compared to the overall market. A high P/E doesn't necessarily mean a stock is overvalued. Any P/E ratio needs to be considered against the backdrop of the P/Es for the company's industry.

Investors not only use the P/E ratio to determine a stock's market value but also in determining future earnings growth. For example, if earnings are expected to rise, investors might expect the company to increase its dividends as a result. Higher earnings and rising dividends typically lead to a higher stock price. For our P/E ratio Tutorial, please read Understanding the P/E Ratio.

Calculating The P/E Ratio

The P/E ratio is calculated by dividing the market value price per share by the company's 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 used typically 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 as shown below.

P/E Ratio p/e ratio

For example, as of the end of 2017 Bank of America Corporation (BAC) closed the year with the following: 

EPS = $1.56

Price = $29.52 

BofA's P/E ratio was: 

P/E = 18.92 or $29.52/$1.56

In other words, BofA was trading at roughly 19xs earnings. However, the 18.92 P/E by itself isn't really 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. However, it's important to compare company P/Es to their peers. For example, JPMorgan Chase & Co. (JPM) had a P/E of 17.84 at the end of 2017. When you compare BofA's P/E of almost 19 to JPMorgan's P/E of just under 18, Bank of America's stock doesn't appear as overvalued as it did when compared to the overall market. 

Analyzing P/E Ratios

As stated earlier, it's important in determining whether a stock is overvalued or undervalued to compare it to its sector or industry group. Sectors are made up of industry groups, and industry groups are made up of stocks with similar businesses like the banking industry. 

In most cases, an industry group will benefit during a particular phase of the business cycle, and therefore many professional investors will concentrate on an industry group when their turn in the cycle is up. Remember that the P/E is a measure of expected earnings. As an economic expansion matures, inflation tends to rise. As a result, the Federal Reserve increases interest rates to slow the economy and tame inflation to prevent a rapid rise in prices. 

Certain industries do well in this environment. Banks for example, earn more income as interest rates rise since they can charge higher rates on their credit products such as credit cards and mortgages. Basic materials and energy companies also get a boost to earnings from inflation since they can charge higher prices for the commodities they harvest.

Conversely, toward the end of an economic recession, interest rates will typically be low, and banks typically earn less revenue. However, consumer cyclical stocks usually have higher earnings, because consumers may be more willing to purchase on credit because rates are low. To learn more about cyclical stocks please read Cyclical Versus Non-Cyclical Stocks.

There are numerous examples of when P/Es of stocks in a particular industry group are expected to rise. An investor could look for stocks within an industry that is coming into favor based on the economic cycle and find those companies with the lowest P/Es as a way to determine which stocks are the most undervalued. For an in-depth example of the P/E ratio using Apple Inc. (AAPL), please read Unlocking The P/E Ratio For Apple.  

Limitations To The P/E Ratio

The first part of the P/E equation or price is straightforward. We can easily obtain the current market price of the stock. On the other hand, determining an appropriate earnings number can be more difficult. Investors must determine how to define earnings and the factors that impact earnings. As a result, there are some limitations to the P/E ratio as certain factors can impact the P/E of a company. Those limitations include:

Volatile market prices can throw off the P/E ratio in the short term. 

Earnings makeup of a company can often be difficult to determine. The P/E is typically calculated measuring historical earnings or trailing earnings. Unfortunately, historical earnings are not much use for investors, since they say very little about what earnings are in store for the years ahead. It's the company's future earnings that investors are most interested in since expected earnings reflect a stock's future prospects.

Forward earnings or future earnings are based on the opinions of Wall Street analysts. Analysts can be overoptimistic in their assumptions during periods of economic expansion and overly pessimistic during times of economic contraction. One time adjustments like the sale of a subsidiary could inflate earnings in the short-term, making predictions of future earnings difficult since the influx of cash from the sale would not be a sustainable contributor to earnings in the long term. Although forward earnings can be useful, they are prone to inaccuracies. For more on the limitations of P/E ratios, please read Beware Of False Signals From The P/E Ratio.

The growth of earnings is not included in the P/E ratio. The biggest limitation of the P/E ratio is that it tells investors little about the company's EPS growth prospects. If the company is growing quickly, you might be comfortable buying it at a high P/E ratio, expecting earnings growth to bring the P/E back down to a lower level. If earnings are not growing quickly enough, you might, in turn, look elsewhere for a stock with a lower P/E. In short, it's difficult to tell if a high P/E multiple is the result of expected growth or if the stock is simply overvalued.

PEG Ratio

A P/E ratio, even one calculated using a forward earnings estimate, doesn't always tell you whether or not the P/E is appropriate for the company's forecasted growth rate. So, to address this limitation, investors turn to another ratio called the PEG ratio.

The PEG ratio measures the relationship between the price/earnings ratio and earnings growth to provide investors with a more complete story than the P/E on its own. 

In other words, the PEG ratio allows investors to calculate whether a stock's price is overvalued or undervalued by analyzing both today's earnings and the expected growth rate for the company in the future. It's calculated as follows: 

PEG ratio
*The number used for annual growth rate can vary. It can be forward (predicted growth) or trailing and can be anywhere from a one-to-five-year time span. Please check with the source providing the PEG ratio to determine what type of growth number and time frame is being used in the calculation.

Since stock prices are typically based on investor expectations of future performance by a company, the PEG ratio can be helpful but is best utilized when comparing if a stock price is overvalued or undervalued based on the growth in the company's industry. 

Stock theory suggests that the stock market should assign a PEG ratio of one to every stock. This would represent the theoretical equilibrium between the market value of a stock and anticipated earnings growth. For example, a stock with an earnings multiple of 20 (P/E of 20) and 20% anticipated earnings growth would have a PEG ratio of one. To learn more, see Introduction To Fundamental Analysis.

Although earnings growth rates can vary among different sectors, typically a stock with a PEG of less than 1 is considered undervalued since it's price is considered to be low compared to the company's expected earnings growth. A PEG greater than 1 might be considered overvalued since it might indicate the stock price is too high as compared to the company's expected earnings growth. 

Example Of A PEG Ratio

A great feature of the PEG ratio is that by bringing future growth expectations into the mix, we can compare the relative valuations of different industries that may have very different prevailing P/E ratios. This makes it easier to compare different industries, which tend to each have their own historical P/E ranges. For example, let's compare the relative valuation of a biotech stock to an integrated oil company:

Biotech Stock ABC
-Current P/E: 35 times earnings

-Five-year projected growth rate: 25%

-PEG = 35/25, or 1.40

Oil Stock XYZ
-Current P/E: 16 times earnings

-Five-year projected growth rate: 15%

-PEG = 16/15, or 1.07

Even though these two fictional companies have very different valuations and growth rates, the PEG ratio allows us to make an apples-to-apples comparison of the relative valuations. What is meant by relative valuation? It is a mathematical way of asking whether a specific stock or a broad industry is more or less expensive than a broad market index, such as the S&P 500 or the Nasdaq.

So, if the S&P 500 has a current P/E ratio of 16 times trailing earnings and the average analyst estimate for future earnings growth in the S&P 500 is 12% over the next five years, the PEG ratio of the S&P 500 would be (16/12), or 1.33. For more on the PEG ratio, please read The PEG Ratio Nails Down Value Stocks

The Bottom Line

The price-to-earnings ratio is one of the most common ratios utilized by investors to determine if a company's stock price is valued properly relative to its earnings. The P/E ratio is popular and easy to calculate, but it has shortcomings that investors need to consider when using it to determine a stock's valuation. 

Since the P/E ratio doesn't factor in future earnings growth, the PEG ratio provides more insight into a stock's valuation. By providing a forward-looking perspective, the PEG is a valuable tool for investors in calculating a stock's future prospects.

However, no single ratio can tell you all you need to know about a stock. Please be sure to use a variety of ratios to arrive at a complete picture of a company's financial health and its stock's valuation.

Every investor wants an edge in predicting a company's future, but a company's earnings guidance statements may not be a reliable source. To learn more, read Can Earnings Guidance Predict The Future?

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