What Is a P/E Ratio? (2024)

How do you tell if that stock or fund you’re considering buying is reasonably priced? If you’re a serious investor, one of the key metrics you likely rely on is the stock’s price-to-earnings, or P/E, ratio.

Basically, it tells you “whether you’re buying a stock when it’s expensive or cheap,” explains Andrew Graham, managing partner and portfolio manager at investment advisor firm Jackson Square Capital in San Francisco.

P/E ratios aren’t of much interest to those who quickly trade in and out of hot stocks. But they matter a great deal to long-term investors. Buy at a low P/E ratio and you’re likely to make more money over the course of a few years; buy high and your stock may drag or lose you money. The idea is that while the price of a stock or fund may zig and zag in the short term, over longer periods it should rise or fall to align with its earnings.

Over the decades, several types of P/E ratios have emerged. This variety can help investors better analyze different kinds of companies, industries and broad market indexes. But P/Es have their limits—they’re useless, for example, when evaluating startup companies that have potential but don’t yet have earnings. And in some cases they can even make stocks that are stinkers look attractive.

Read on to see how P/E ratios are calculated, when to use them and to understand some of the key variations on the basic formula.

What is a P/E ratio?

P/E ratios are calculated by dividing a company’s stock price per share by its earnings per share. This shows you how much the market is willing to pay for a company’s earnings. “For example, if a company is selling at a 15 P/E, it means you’re paying 15 times what it makes each year,” says Howard Silverblatt, a senior index analyst at S&P Dow Jones Indices. One can average multiple companies’ earnings and prices to get a collective P/E—like that of the .

P/Es are a comparative tool. They can help determine whether a stock is cheap or expensive compared with its historical averages or to similar stocks. They’re often used to tell whether the market is “expensive” at a given time. The stocks in the S&P 500 index recently traded at about 23 times earnings. Since their average over the past 30 years is closer to 19 times earnings, the index is indeed a bit expensive now, says Andrew Krei, co-chief investment officer at Crescent Grove Advisors, in Milwaukee.

P/E ratios became popular after the Securities Exchange Act of 1934 forced publicly traded companies to share earnings and other financial information quarterly. “Prior to that it was almost like, ‘Our business is none of your business,’” says Douglas Ramsey, chief investment officer at investment firm The Leuthold Group, in Minneapolis.

Early adherents used the earnings companies reported over the past four quarters as the basis for their calculations. While these so-called trailing 12-month, or TTM, P/E ratios are still commonly used, other variations have popped up, most notably forward P/Es, which rely on Wall Street’s estimates of companies’ future earnings.

P/E ratios are not a perfect tool for evaluating stocks. A company’s attractive trailing P/E ratio might belie the fact that its earnings are about to fall off a cliff. A forward P/E ratio might be based on projected future earnings that fail to materialize. That’s why investors should look beyond P/E ratios to consider factors like a company’s overall financial health, its growth prospects and the potential impact of economic conditions.

How to interpret a P/E ratio

Is a stock with a P/E ratio of 20 a good deal? The context is everything. For example, typical P/E ratios vary across industries due to differences in growth rates and other factors. Tech companies, often known for explosive earnings growth, tend to sport higher ratios than, say, utility companies, with their regular dividends and slow-and-steady earnings growth. The tech-heavy Nasdaq index recently sported a TTM P/E around 28, while the S&P 500 Utilities Select Sector Index was at 22.

“The faster a company is able to grow earnings, the higher the price you should be willing to pay,” explains Ramsey. “Conversely, a company with weaker growth prospects deserves a lower price.”

It’s important to note that a low or high P/E doesn’t mean the stock price won’t rise over time. A growth-oriented tech firm with a 30 P/E and a value-oriented utility with a 20 P/E can both make you money if you buy at a reasonable price.

Types of P/E ratios

Just as a tape measure is a better tool than a ruler for measuring your waistline, different types of P/E ratios are best suited to gauge different types of stocks and industries.

Forward P/E

Forward P/Es are based on Wall Street estimates for a company’s profits in the coming year. This version of the P/E ratio can be useful if a company is growing quickly, and last year’s profits don’t capture its full potential, or if analysts are expecting a sharp decline in profits that might not be captured in a “backward looking” number.

That said, analysts’ estimates should always be taken with a grain of salt. Wall Street doesn’t have a crystal ball. Also forward P/Es tend to be based on “operating earnings,” an-often rosy take on a company’s performance that doesn’t necessarily include one-time expenses.

Forward P/Es caught on in the 1970s and ’80s with the rise of tech and growth-oriented companies whose potential couldn’t be fully captured by past earnings. It’s valuable for any industry where future earnings significantly impact present valuation. Along with tech, examples include biotech and renewable energy. It’s also useful for old-school industries that anticipate future booms—think Detroit shifting to electric cars.

Shiller P/E

Also known as the Cyclically Adjusted Price-to-Earnings, or CAPE, ratio, the Shiller P/E aims to smooth out fluctuations in inflation and in companies’ earnings to provide a more accurate valuation picture. “Schiller makes sense in industries where the earnings are much more volatile year to year,” says Ramsey.

The materials industry—think mining or lumber companies, for example—tends to rise and fall sharply based on fluctuating economic strength and consumer demand. By averaging a company’s inflation-adjusted earnings over, say, the past 10 years and dividing that number into the current stock price, investors get a clearer picture of whether the stock’s current price is reasonable.

The PEG ratio

The price/earnings-to-growth ratio, or PEG ratio, was developed to analyze fast-growing sectors like tech. It builds on forward P/E by factoring in not just a year of anticipated earnings but the longer trajectory of earnings growth. The PEG ratio is popular in part because it’s easy to interpret: a ratio higher than 1.0 suggests a stock is overvalued, while a ratio below 1.0 indicates it’s cheap.

Alternatives to P/E ratios

P/E ratios have become a popular form of shorthand for judging an investment’s attractiveness. But other valuation metrics can buttress investors’ stock analysis, or provide guidance when P/E isn’t the right tool. Price to sales

Price-to-sales measures a stock’s price relative to revenues rather than earnings. It’s often used to analyze companies with volatile profits—think airlines or pharmaceutical companies—or early-stage businesses that don’t yet have significant earnings. “Software-as-a-service names were the poster children for price-to-sales multiples over the past number of years,” says Krei. “You had a kind of growth-at-all-costs approach, it wasn’t about generating earnings.”

Price to book

Comparing a company’s stock price to its book value—its total assets minus total liabilities—is another analytical approach. The price-to-book ratio reflects the theoretical amount shareholders would receive if all assets were liquidated and debts paid off. It’s popular for research in asset-heavy industries like banks.

Got a money question? Let Buy Side find the answer.Email[emailprotected].

Include your full name and location, and we may publish your response.