Price-to-Earnings P E Ratio: Definition, Uses, Formula, Calculation, Types, Factors, Limitations

Assessing factors like shareholders’ equity, book value, and EPS growth on the balance sheet – alongside the P/E ratio – enables a more informed view of a stock’s valuation. This additional financial context is key for evaluating risk-return profiles. A higher P/E ratio generally indicates that investors expect higher growth from the company in the future. This is possible because while the market price of stock can’t be negative, the earnings per share of a company can be negative. Investors and traders sometimes interpret the earnings yield as the amount of earnings one receives for each dollar invested in the company’s shares.

Still, a higher P/E ratio may indicate that a stock’s price is overvalued. Depending on the valuation, some companies have a higher Price-to-Earnings ratio, and others have a lower one. Understanding what that means and how you can use it to compare stocks to others gives you an edge in determining which stocks are the most profitable. Along with the many tools, the Price-to-Earnings ratio directly ties into whether or not stocks are over or undervalued. Understanding the P/E ratio will help you better understand how important it is for investors to evaluate stocks before committing to their investment. An advantage of using the PEG ratio is that you can compare the relative valuations of different industries that may have very different prevailing P/E ratios.

But if an investor or trader expects the company to produce greater earnings growth than the market expects, he/she may view that stock as a good investment. In India, the two most tracked equity indices are the Nifty 50 and the Sensex. Their historical P/E ratios provide insights into how Indian equities have been valued over different market cycles.

P/E vs. Earnings Yield

Download our forward P/E ratio template to use your own numbers in Excel and perform a forward-looking valuation of companies. After downloading the template, input their current share prices and two years of future EPS estimates, and the P/E ratios will automatically be calculated. Calculating a company’s P/E ratio may initially seem complex, but it’s easy to understand once you understand a few fundamental concepts.

1. For example, a consumer staples company with a 25% operating margin could warrant a P/E of 18-20x.
2. However, when it comes to single stocks, there may be a good reason for a specific company to have a P/E above 17.
3. The Covid-19 pandemic resulted in a sharp correction and slide in earnings during the first half of 2020.
4. For example, a high-debt company sometimes trades at 8-12x P/E, while a similar low-debt company trades at 12-16x.
5. Investors use the P/E ratio to determine not only a stock’s market value but also its future earnings growth.

Diluted Earnings Per Share Calculation (EPS)

Strike offers a free trial along with a subscription to help traders and investors make better decisions in the stock market. Since the stock market is forward-looking (as opposed to backward), it places more emphasis on what is expected to happen in the future, rather than what happened in the past. A negative or extremely high P/E ratio typically signals problems for a company’s stock. Any major discrepancy, a large or small number, is never a good sign and usually falls under an unhealthy Price-to-Earnings ratio category. Even so, investors will always heavily prefer trailing P/E over forward P/E because of the uncertainty of a company’s forward P/E ratio.

Where to Get the Estimated EPS

Therefore, in this example, an earnings yield of 5% suggests that each dollar invested into ABC’s shares generates $0.05 of EPS. For example, comparing the P/E ratio of XYZ to the broader S&P 500, one can see that XYZ trades at a lower multiple than this large, diversified index (12 vs 17). That may indicate the market thinks XYZ will generate lower earnings growth as compared to the average company in the S&P 500.

The firm with more debt will likely have a lower P/E value than the one with less debt. However, if the business is solid, the one with more debt could have higher earnings because of the risks it has taken. In general, a high P/E suggests that investors expect higher earnings growth than those with a lower P/E. A low P/E can indicate that a company is undervalued or that a firm is doing exceptionally well relative to its past performance. When a company has no earnings or is posting losses, the P/E is expressed as N/A. When you compare HES’s P/E of 31 to MPC’s of 7, HES’s stock could appear substantially overvalued relative to the S&P 500 and MPC.

Even within an industry, target P/E ratios are able to vary based on growth projections, competitive advantages, risk profiles and other factors. Their earnings fluctuate significantly over economic cycles, falling during recessions and peaking during expansions. Investors apply lower multiples due to the volatility and unpredictability of their earnings. Companies facing competitive threats or disruption also sport lower P/E ratios. Investors sometimes are concerned about declining market share, shrinking margins, or other challenges to profitability that constrain earnings growth. Oftentimes, so-called “value traps” appear cheap based on P/E but suffer from structural industry issues.

Investors love stocks with growth potential, and if a company shows above-average growth potential, investors will certainly take notice of that stock. Companies can improve their growth potential by breaking into new markets or improving their standings in their current market with new innovative technologies. The main purpose of the P/E ratio is to help investors make informed purchasing decisions about a stock based on its current earnings.

Justified P/E tries to determine an appropriate multiple based on projected growth rates. A PEG greater than one might be considered overvalued because it suggests the stock price is too high relative to the company’s expected earnings growth. A company’s earnings and sales growth is a major determinant of its P/E ratio. Faster-growing companies tend to command higher P/E ratios while slower-growing companies have lower P/E ratios. Investors are willing to pay more for shares of high-growth companies as they expect higher future earnings potential. As a result, high-growth companies like technology and consumer stocks often trade at elevated P/Es compared to slower-growing companies.

Can the P/E ratio be negative?

1. Evaluating both historical earnings and future projections provides a more complete perspective on determining valuation through P/E analysis.
2. The election of a stable NDA government in 2014, coupled with reforms like GST, gave a boost to market sentiment.
3. The P/E should be assessed alongside profit margins, debt levels and other factors to judge earnings quality.
4. Investors will not be willing to pay a high earnings multiple if earnings are expected to remain flat or grow minimally over time.
5. The trailing P/E ratio will change as the price of a company’s stock moves because earnings are released only each quarter, while stocks trade whenever the market is open.

The Covid-19 pandemic resulted in a sharp correction and slide in earnings during the first half of 2020. But massive global liquidity infusion and quicker-than-expected demand recovery lifted the markets. The Nifty P/E hit a record high of 36.4 times in October 2021 before moderating to around 20 times now. A company’s return on equity (ROE) and return on capital employed (ROCE) also influence its P/E ratio. Companies with higher ROE and ROCE tend to have higher P/Es since they generate more profits from the capital invested in the business. For example, an FMCG company with a ROE of 22% could trade at a P/E of 25-30x, while another FMCG firm with a ROE of just 15% would warrant a lower P/E of 18-22x.

Track all your Financial KPIs in one place

It can be difficult to tell if a high P/E multiple is the result of expected growth or if the stock is simply overvalued. Below is a break price to earnings ratio formula down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.

Moreover, the exact estimate used for the earnings growth rate will also vary. For example, one analyst may estimate the earnings growth rate over a 1-year period, using one set of assumptions. While another analyst may estimate the growth rate over a 1-year period, using a different set of assumptions. One important limitation of the PEG ratio is that it relies heavily on the earnings growth assumption used in the calculation. For example, one could use a 1-year earnings growth rate, a 3-year earnings growth rate or a 5-year earnings growth rate. As such, the P/E ratio provides market participants with an important data point that can be used to further analyze the market valuation of a given company.