Price-to-earnings ratio explained

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When a shopper goes looking for a new appliance, perhaps a coffee maker, they may ask themselves questions like: “Is this worth the price?” and “What type of lifetime value will I get out of the purchase?”

These are great questions to ask about any purchase, stocks included. And inquiries into a stock’s price and value are cornerstones of stock market research.

Investors may frame the questions like this: “Is this stock worth it for the price?” and “What type of value will I get out of this stock?”

To answer these questions, where would someone even begin?

Investors may want to begin by considering its price-to-earnings ratio. This figure gives a quick read on how much a stock costs as compared to the profitability — the earnings — of that same company.

That said, the price-to-earnings ratio alone does not tell an investor everything they need to know about a stock. It may not even tell an investor whether a stock is good or bad.

But the price-to-earnings ratio formula is a useful tool in the toolbox of methodologies available for all investors interested in doing stock analysis.

Related: Investing vs. saving: finding a balance

What is a Price-to-Earnings Ratio?

The price-to-earnings ratio (P/E ratio) gives investors a glimpse into the relationship between a stock’s price and the profitability of that company. Investors see how much they’re paying for each dollar of earnings. This is done by comparing the price of a single stock as compared to that company’s earnings, calculated on a per-share basis.

A P/E ratio may be most useful when used in comparison to other stocks, or to its past performance. It is not quite as useful without context, but we’ll come back to that below.

First, here’s a quick review of some concepts that are important to understanding a stock’s P/E ratio.

A stock represents a share of ownership in a company. When an investor owns a stock, they quite literally own part of that company. That means taking part in both its failures and its successes. When a company profits, an investor is a partial owner of those profits. This, of course, is the allure of investing in stocks.

A company’s earnings reveal how profitable they were during the previous period, whether that’s the most recent quarter, year or even the company’s lifetime. Earnings refer to revenue minus costs, so investors are indeed looking at a figure that represents profit. There may be no more popular measure of a company than its earnings.

Earnings per share (EPS), then, shows investors how much of the company’s profits belong to each shareholder. To get the EPS, simply take a company’s earnings and divide by a stock’s per-share price.

Companies that issue common stocks are called “public” companies because the public can own shares of that company. Publicly traded companies are required to report their earnings on a quarterly basis. Shareholders may even be allowed to participate in a company’s quarterly earnings call, where earnings are discussed.

This is important to understand: A stock share represents a proportion of ownership in that company. Though the price of that share may change, the investor’s stake in the company does not.

Here’s another way to look at it: If a company divided itself into 10 shares, and an investor-owned one of those shares, it does not matter whether they bought it for $10 or $100. They still own exactly 10% of that company. The question for investors, then, is whether the stock is a good buy at its current price. Enter the P/E ratio.

It’s easy to look up a P/E ratio on any site that aggregates information about stocks, like Morningstar or Bloomberg. Still, it is helpful to know how the calculation is made so it’s not just some number on a page.

What is the Price-to-Earnings Ratio Formula?

When looking at the price-to-earnings ratio formula, the stock’s price (P) sits on the top of the equation as the numerator, and earnings per share (E) hangs out at the bottom as the denominator.

To get the “P,” find the price of one share of a company’s stock. This is the easy part.

To get the “E,” determine a company’s earnings per share (EPS) by dividing a company’s total earnings by its number of shares. (Again, doing the calculation isn’t actually necessary. This number is easy to look up.)

Generally, this calculation is prepared using a company’s earnings over the previous year. Specifically, these are called trailing earnings. This is also sometimes expressed as “TTM,” which stands for “trailing 12 months.”

It is possible to do the same calculation using future earnings predictions. These are called forward earnings or forward-looking earnings. It should be clear if the calculation is using forward-looking earnings numbers.

Here’s an example: Say a company has made available 12 shares of ownership. Each share is priced at $15. That per-share price, the $15, is the number that goes on the top of the P/E equation.

P = $15

This same company had $12 of earnings during the last year. Therefore, the EPS is $1 since each of the 12 shares gets an equal cut of the profits. That’s the bottom half of your equation.

E = $12/12 = $1

The P/E ratio is 15/1, or 15.

Because it is a simple ratio, the general rules that apply to fractions apply here, too. When the price is higher or the earnings are lower, P/E goes up. When the price is lower or the earnings are higher, P/E goes down.

It may seem easy, then, to conclude that a lower number is better because there are higher earnings per each dollar of stock. Unfortunately, such an assumption may be oversimplified.

Which naturally begs the question, what is a good P/E ratio for stocks?

What is a Good Price-to-Earnings Ratio?

A high or low P/E ratio is not necessarily good or bad.

For example, if the P/E ratio of a company is low, it could indicate that the company’s stock is underpriced and represents a good value. (FYI, this is what “value” investors, like Warren Buffet, are trying to sniff out.)

But it could also be an indication that investors are actively selling shares and driving the price down. Perhaps this has happened suddenly before earnings figures have been reported for that quarter. Such a wide-scale selloff would generally indicate that investors are losing confidence for some reason, and a low P/E is an alarm.

If the P/E ratio of a company is high, it could be an indication that investor excitement is too high, especially if earnings remain low, thereby representing poor value. This could even be an indication of a stock bubble.

But a high P/E could also indicate widespread investor confidence in a company’s position to grow and expand.

So, what is a good price-to-earnings ratio for stocks? Naturally, this is a question with no universally agreed-upon answer. Further, what is considered to be an acceptable P/E ratio has changed over time.

Legendary investor Benjamin Graham stated that any P/E ratios over 16 should be avoided in his book “Securities Analysis.” But P/E ratios across the board were much lower in 1934, when his seminal work was published.

During the years between 2010 and 2020, the average P/E ratio of the S&P 500 ranged between 14 and 27.

It’s common to see a P/E of 15 used as a benchmark for a fairly priced stock. P/Es that fall below 15 may be considered a good value, and P/Es that fall above could be considered a bad value.

Because the average P/E for U.S. stocks seems to be a lot closer to 20 these days, some might argue that the goalposts have moved. But, again, there is no real way to know. And that’s because knowing would require being able to tell the future.

Pros and Cons of the P/E Ratio

The P/E ratio is an interesting data point that makes for an important and reasonable starting place for stock investors. Investors researching stocks should absolutely consider the P/E ratio before making a purchase.

That said, it may be ill-advised to make a decision about a stock based on its P/E alone.

A stock’s P/E ratio should be considered in the greater context of what’s happening with a company. For example, it’s possible to imagine that two companies have the same P/E ratio while one is careening towards bankruptcy and the other is growing. The P/E data point alone would not tell us which is which.

Knowing that, taken P/E into consideration with other factors, such as market share and growth opportunity, balance sheet strength, price-to-book ratio, and dividend payments, is recommended. Similarly, it may help to look at a company’s P/E ratio as compared to other companies within the same industry or to historical P/E ratios.

Another downside of using the P/E ratio is that it measures backward in time. It considers what’s already happened. And part of being a good stock-picker is being able to foresee what is going to happen in the future. If it sounds like a tough job, well, it is. And unfortunately, there is no one data point that can act as a crystal ball.

What is an Earnings Yield?

A P/E ratio should not be confused with the earnings yield. The two express similar ideas, but in different ways.

The earnings yield is the reciprocal of the P/E ratio. Take EPS and divide by the stock’s price. Instead of P/E, the calculation is E/P. The resulting value is expressed as a percentage.

Using the example from above, where the stock trades for $15 and the EPS is $1, the earnings yield calculation is 1/15, or 6.7%. Although a bit crude when used as a predictive tool, this could represent the potential return on investment. Remember, returns are not guaranteed in the stock market.

Why? With stocks, there is generally always a great deal of uncertainty as to whether a company will earn its predicted yield for the year. Not only is the nature of business unpredictable, but stock prices can fluctuate wildly.

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

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