The price-to-earnings ratio (P/E) is one of the most widely used metrics for investors and analysts to determine 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 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. 

Companies that grow faster than average typically have higher P/Es, such as technology companies. 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 historically ranged from 13 to 15.

For example, 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 does not necessarily mean a stock is overvalued. Any P/E ratio needs to be considered against the backdrop of the P/E 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.

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 (EPS) 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 valuation ratio as shown below.

Analyzing P/E Ratios

As stated earlier, to determine whether a stock is overvalued or undervalued, it should be compared to other stocks in its sector or industry group. Sectors are made up of industry groups, and industry groups are made up of stocks with similar businesses such as banking or financial services. 

In most cases, an industry group will benefit during a particular phase of the business cycle. 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 economies mature, 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 receive 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 tend to earn less revenue. However, consumer cyclical stocks usually have higher earnings because consumers may be more willing to purchase on credit when rates are low.

There are numerous examples of scenarios where the P/Es of stocks in a particular industry are expected to rise. An investor could look for stocks within an industry that is expected to benefit from the economic cycle and find the companies with the lowest P/Es to determine which stocks are the most undervalued.

Limitations to the P/E Ratio

The first part of the P/E equation or price is straightforward as the current market price of the stock is easily obtained. 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. 

The earnings makeup of a company is often difficult to determine. The P/E is typically calculated by measuring historical earnings or trailing earnings. Unfortunately, historical earnings are not of much use to investors because they reveal little about future earnings, which is what investors are most interested in determining.

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 such as the sale of a subsidiary could inflate earnings in the short term. This complicates the predictions of future earnings 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.

Earnings growth is not included in the P/E ratio. The biggest limitation to the P/E ratio is that it tells investors little about the company’s EPS growth prospects. If the company is growing quickly, an investor 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, an investor might look elsewhere for a stock with a lower P/E. In short, it is 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, does not always show whether or not the P/E is appropriate for the company’s forecasted growth rate. 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 alone. 

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 is calculated as follows:

Example of a PEG Ratio

An advantage of using the PEG ratio is that considering future growth expectations, we can compare the relative valuations of different industries that may have very different prevailing P/E ratios. This facilitates the comparison of different industries, which tend to each have their own historical P/E ranges. For example, below is a comparison of the relative valuation of a biotech stock and an integrated oil company:

Even though these two fictional companies have very different valuations and growth rates, the PEG ratio gives an apples-to-apples comparison of the relative valuations. What is meant by relative valuation? It is a mathematical way of determining 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.

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.

The Bottom Line

The price-to-earnings ratio (P/E) is one of the most common ratios used 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 should consider when using it to determine a stock’s valuation. 

Since the P/E ratio does not 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 investors all they need to know about a stock. It is important to use a variety of ratios to arrive at a complete picture of a company’s financial health and its stock 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.