Is a stock a bargain or overpriced? This is a basic question for every investor, and there are any number of ways to answer it. But one of the best places to start is by looking at what is known as the price-to-earnings ratio, a yardstick that every investor should be familiar with and understand.

What is a price-to-earnings ratio?

A price-to-earnings ratio, or P/E, refers to the relationship between a company’s stock price and its earnings, or net income. It’s also referred to as the price-earnings multiple because the stock price will usually be several times more than earnings.

The P/E ratio answers this question: how expensive is the stock price, relative to the company’s profitability? The ratio is also used for sectors—companies grouped by same or similar industries—and for broader market indexes such as the Standard & Poor’s 500 and the technology-heavy Nasdaq.

How to calculate P/E ratio

Here is a simple example of how to calculate the P/E ratio: Company A’s stock price is $120, and its earnings for the most recent four quarters were $6 a share. The price-to-earnings ratio is:‍

120/6 = 20

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This means that an investor is willing to pay 20 times the amount of Company A’s earnings to own a share—or said another way, an investor is willing to pay $20 to own a claim on a dollar of the company’s earnings. The price-earnings ratio, then, is investors’ collective opinion about a company’s profitability.

An investor uses P/E comparisons to determine how expensive a stock is, relative to other stocks, to the stock’s sector, or to broader market indexes. If Company B’s current stock price is $90 and its recent earnings were $3 a share, its P/E ratio is:‍

90/3 = 30

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So even though a share of Company A nominally costs more, it’s less expensive than Company B from a relative price-earnings basis.

Inverse of P/E: Earnings yield

The inverse of a P/E ratio is the earnings yield—earnings divided by price in percentage terms—and investors sometimes use this comparison as well. For Company A, earnings yield is $6/$120 = 0.05 or 5%. For Company B, the yield is $3/$100 = 0.0333 or 3.33% . Company A again looks like a relatively better bargain. Earnings yield is merely an upside-down way of looking at the P/E ratio.

What’s a good P/E ratio?

The key word for answering the question, “What’s a good P/E ratio?” is it’s all relative. A price-earnings ratio in isolation means little. It must be considered relative to a number of other things. These can include:

• Other companies’ P/E ratios.

  For example, the P/E ratio of a company such as ExxonMobil’s could be compared with Chevron’s P/E.

• Industry averages.

  Using the same company, an investor might compare ExxonMobil’s P/E with that of the energy sector’s average P/E.

• Historical average.

  ExxonMobil’s current P/E could be compared with its historical average, giving an investor insight into whether the share valuation is higher or lower than in the past.

• Markets.

  An investor could compare a company against the broad stock market—ExxonMobil’s P/E against the S&P 500’s ratio. Sector and index P/E ratios can be compared as well; the energy sector against the health-care sector, or the S&P 500 against the Nasdaq Composite.

Some companies may show N/A for price-earnings ratio, meaning not applicable, or a negative sign in front of the ratio. That means the company had no earnings, or that it reported a loss. Typically, N/A will appear, rather than a negative ratio.

A company can have a bad year and then recover, restoring its positive P/E ratio. But repeated losses indicate higher risk because investors don't know if the company will ever become profitable again. Then again, look at Amazon. Founded in 1994, it didn’t have a profitable year until 2003, when its stock price was about $50.

Types of P/E Ratios

Investors can compare the ratios in several ways:

Current, using trailing 12-month (TTM) earnings

This usually refers to the last four quarters of reported earnings For example, if a company’s fiscal year is a regular calendar year Jan. 1 to Dec. 31, and the investor is considering an investment in August, she will add earnings for the third and fourth quarters of last year and the first and second quarters of this year, using this as the P/E denominator.

Future or forecast earnings

This is called the forward P/E ratio. It can be based on a company’s forecast for future quarters or the year, or estimates among securities analysts. Investors study the forward P/E ratio because their investment decisions are forward-looking: earnings for the year ahead can matter more than earnings in the year behind.

A forward P/E that is lower than a trailing P/E suggests that investors and analysts expect a company’s earnings to grow.

Shiller P/E, historical earnings

These also can be used to get a long-term picture of price-earnings valuation. The Shiller P/E ratio is the best known, and is used to evaluate market indexes and sectors, not individual stocks. The Shiller model, devised by Nobel Prize economist Robert Shiller and focused on the S&P 500, divides the index price by the inflation-adjusted average of index earnings for the past 10 years (40 quarters).

Professional investors use the Shiller ratio because it accounts for inflation and because it uses a 10-year period, enough to incorporate a full cycle of the economy—strong-growth and weak-growth years. A shorter time span might catch only one part of the cycle and thus produce a distorted P/E ratio. For this reason the Shiller ratio also is called the Cyclically Adjusted Price-Earnings (CAPE) ratio, because it smooths out the undulations of an economic cycle.

P/E ratios in 2021

As of August 2021, price-earnings ratios were near record highs, meaning that stocks were expensive by historical standards. The S&P 500, the most widely used benchmark for the stock market because the 500 companies in the index account for about three quarters of the U.S. stock market’s value, stood at about 31 in mid-August 2021. That is almost twice the index’s average P/E of the past century.

The Shiller ratio for the S&P 500, meanwhile, is the highest since the 2008-2009 financial crisis and the dot-com stock market bubble of the late 1990s. For the 141 years that Shiller has studied quarterly data, in only 4% of the quarters has the price-earnings ratio been higher.
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Chart source: GuruFocus.com

These high P/E levels should prompt investors to consider forward-looking ratios. Because the forward P/E is the current stock price divided by future/expected per-share earnings, a lower forward P/E suggests higher future earnings. One estimate from a leading market economist sees a forward P/E ratio of 21 for the S&P 500. The Nasdaq 100 index, comprising the 100 biggest companies listed on Nasdaq, has a current P/E of 36, coming down from a peak of 116 in 2017; its forward P/E ratio is 29.

Another such measure, the price-to-earnings-growth (PEG) ratio, is used to assess whether stocks are undervalued or overvalued. It is the current P/E of the stock or index, divided by the rate of expected earnings growth. A ratio above 1 generally means overvaluation, and below 1, undervaluation.

The S&P 500 has a current PEG ratio of about 3.4 as of mid-August.

Looking ahead

Investors should remember a few things when trying to look ahead by examining forward P/E ratios:

• The ratios are based on estimates. They are only best guesses, using available information.
• Who is doing the estimating? Are earnings projections coming from the company, or from securities analysts and other outsiders? Different estimates can result in different expected ratios.
  Has the company been reliable in the past with projections? Have analysts’ expectations been close to the mark, or way off?
• Company projections can be subject to manipulation. For instance, a company might underestimate earnings, making it easier to exceed analysts’ expectations when earnings are reported.

Other useful ratios

P/Es ratios can be a useful guidepost for investors, but not the only one. A high ratio might look alarming at first; but it might be justified by the company’s earnings growth rate. And a low ratio might lure investors into a seeming bargain, a so-called value stock, only to discover there are reasons the stock has a low P/E multiple with little growth prospects, such as being in a stagnant industry.

Other ratios can be used in conjunction with price-earnings to assess the suitability of a company’s stock:

• Price-to-sales ratio

  , which is the company’s total market capitalization divided by its total sales or revenue for the trailing 12 months. Useful for companies that aren’t yet profitable or that have temporary losses.

• Price-to-cash-flow ratio

  , the company’s stock price divided by its operating cash flow per share. Useful for companies that have little or no net income after non-cash expenses for depreciation and amortization.

• Price-to-book ratio

  , which is the current stock price divided by the per-share value of shareholders’ equity market value over book value. A ratio below 1 suggests the company is undervalued. This is suitable for evaluating capital-intensive industries such as energy and transportation; not suitable for companies with intangible assets such as intellectual property.

• Profit margins.

  A basic way to evaluate whether a company is controlling costs while generating sales. Investors may use net income, operating profit or EBITDA (earnings before interest, taxes, depreciation and amortization) as the basis.

• Return on equity, return on assets.

  These are considered particularly useful in measuring a company’s financial condition. They are expressed as percentages.‍

• Return on equity (ROE)

  is net income divided by shareholders equity. Higher ROE means a company is making good use of shareholder equity in generating earnings. The long-term average return on equity for the S&P 500 is about 14%, for comparison.‍

• Return on assets (ROA)

  is net income divided by total assets. Like ROE, it’s a measure of how efficiently a company uses its resources to generate earnings. Unlike ROE, it includes debt: total assets are debt plus shareholder equity.‍

• Debt-to-equity ratio, and debt-to-total-capital.

  Debt-equity is a company’s total debt divided by shareholder equity. Debt-to-total-capital is total assets, debt plus equity.

The bottom line

Investors should remember that the price-earnings ratio is a good starting point for evaluating investment choices in stocks, sectors, and indexes, but it is not sufficient on its own. A company’s price-earnings ratio should be viewed together with other ratios -- whether those are ratios linked to the market price or fundamental ratios derived from companies’ business performance -- and other fundamental research.

Because the purpose of ratios is to compare investment choices, investors need to make sensible comparisons—apples to apples, not apples to oranges. Simply using price-earnings to compare a software company against a supermarket chain, for example, wouldn’t make sense. The two industries have very different dynamics. Similarly, ratio analysis will be quite different for a technology sector fund than a banking-finance sector fund.

P/E ratios are a key tool investors use to help them make decisions. But they are only useful as an indicator when used with other information to make comparisons—against other companies, other industries, indexes, as well as past earnings and expectations of future profitability.‍