What is the P/E ratio, and what can it tell you about a stock?

How is the P/E ratio calculated?#

The SEC's Investor.gov glossary gives the formula: the ratio is calculated by dividing the current stock price by the current earnings per share^[1]. Earnings per share (EPS) is calculated by dividing the earnings for the past 12 months by the number of common shares outstanding^[1]. Earnings here means net income, also called net profit — the bottom line of the income statement^[2].

The SEC's guide to financial statements gives a one-line example: if a company's stock is selling at $20 per share and the company is earning $2 per share, its P/E ratio is 10 to 1^[2]. In other words, buyers are paying $10 for every $1 of the company's yearly earnings.

1. 1

   Find net income

   Take the company's net income for the last 12 months from its income statement, in its 10-K or 10-Q filings.

2. 2

   Divide by shares outstanding

   That gives earnings per share (EPS). Many reports already show EPS.

3. 3

   Divide the price by EPS

   The current share price divided by EPS is the P/E ratio.

4. 4

   Put it in context

   Compare it with the company's own history and with similar companies in the same industry.

What does a high or low P/E mean?#

FINRA describes the ratio as telling you how much investors are paying for a dollar of a company's earnings^[3]. A stock with a comparatively high P/E trades at a higher price relative to its EPS^[4]. FINRA adds that fast-growing companies tend to have higher P/E ratios, while firms in mature, slow-growth industries tend to have lower ones^[4].

That is the heart of it. A high P/E usually means investors expect earnings to grow; a low P/E usually means they expect slow growth or see more risk. Neither is good or bad on its own. A high P/E can be justified if growth arrives — or painful if it does not. A low P/E can be a bargain — or a sign that the business is shrinking.

How do you compare P/E ratios fairly?#

FINRA says P/E is generally used to compare companies in the same industry^[4], and advises looking at how ratios compare with the market as a whole and with a company's particular industry, since average ratios can vary significantly across industries^[3]. Investor.gov frames the ratio as a way of gauging whether a stock price is high or low compared to the past or to other companies^[1].

Watch which earnings figure is used. Investor.gov's definition uses the past 12 months of earnings^[1], often called a trailing P/E. Some websites also show a P/E based on analysts' forecasts of next year's earnings. Both are labelled "P/E", so check the fine print before comparing. FINRA also notes that EPS can be calculated on a basic or a diluted basis, which counts shares that could be created later^[4].

When does the P/E ratio mislead?#

The P/E is only as good as the earnings in the denominator. When earnings fall, the ratio rises even if the price does not move. When earnings are near zero, the P/E becomes very large; when the company loses money, there is no meaningful P/E at all.

Earnings can also swing for one-off reasons, such as selling a factory or writing down an asset. A single unusual year can make a company look cheap or expensive when nothing about its long-run business has changed. Reading the company's annual report, the 10-K, alongside the ratio helps; the SEC makes these filings free on EDGAR^[5].

How does the P/E relate to market capitalization?#

You can also calculate a P/E for the whole company. Multiply the share price by the shares outstanding and you get the company's market capitalization — FINRA describes market cap as simply the current share price times the number of outstanding shares^[6]. Divide that by total net income and you get the same P/E. In the example above, Steady Co's market cap is $6.0 billion and its net income is $300 million: 6,000 ÷ 300 = 20.

Indexes have P/E ratios too, built from the prices and earnings of all their members. Our note on stock market indexes explains how those baskets are weighted.

What mistakes do beginners make?#

1. Calling a low-P/E stock cheap without asking why

   A low P/E can mean investors expect earnings to shrink. Read why before assuming a bargain.

2. Comparing P/Es across unrelated industries

   Average ratios differ widely by industry. Compare a company with its peers and its own history.

3. Mixing trailing and forward P/Es

   One uses past earnings, the other uses forecasts. Check which one a website shows before comparing two numbers.

4. Ignoring one-off earnings swings

   A big one-time gain or loss can distort a single year's EPS. Look at several years of earnings.