Price-to-Earnings ratio explained: What it is and how to use it

Different types of P/E ratios

When you look at a stock's P/E ratio, you'll find there are a few different types to consider, each telling you something slightly different about the company's valuation.

Trailing P/E ratio

This type of P/E ratio is based on the company's earnings over the past 12 months. Investors like the trailing P/E because it relies on actual data, making it a reliable metric for understanding how a stock performed recently. However, one limitation is that it only reflects past performance, and companies can change quickly.

Forward P/E ratio

Unlike the trailing P/E, the forward P/E looks at the company's projected earnings for the next 12 months. It helps anticipate how a stock might perform in the future, but it comes with risks—especially if the earnings forecasts aren't accurate.

Sometimes, analysts or companies themselves can be overly optimistic or pessimistic about future performance, which could lead to misleading ratios.

Cyclically Adjusted Price-to-Earnings (CAPE) ratio

The CAPE ratio takes a longer view, using the average earnings over a period of 10 years, adjusted for inflation. It's often used to evaluate overall market performance, like the S&P 500, and is handy for smoothing out earnings fluctuations that can happen during different stages of a business cycle.

How to use the P/E ratio in stock analysis

The P/E ratio can be a powerful tool, but its effectiveness depends on how you use it in context. Comparing a company's P/E ratio to others in the same industry and to its own historical P/E can give you a clearer picture of whether a stock is overvalued or undervalued.

High P/E ratio vs. low P/E ratio

A high P/E ratio typically means that investors expect significant growth from the company. For example, a P/E ratio above 25 is often considered high, indicating that investors are willing to pay more for each dollar of earnings, expecting the company's profits to rise in the future. Tech companies like Amazon often have high P/E ratios because of their rapid growth potential.

On the other hand, a low P/E ratio (usually below 15) could suggest that a stock is undervalued. However, it can also be a sign that the company isn't expected to grow much or that there are concerns about its financial health. Value stocks often have lower P/E ratios because of their slower growth rates.

Comparing P/E ratios by industry

Different industries tend to have varying average P/E ratios due to their growth rates, business models, and market expectations.

Here's a rough breakdown of typical P/E ranges across sectors:

• Technology. 20–40 (higher P/E ratios are common due to rapid growth expectations).
• Financials (Banks). 10–15 (a lower range because banks are more stable and have slower growth).
• Healthcare. 15–25 (this varies depending on whether the company is in pharmaceuticals or medical devices).
• Utilities. 10–20 (utilities have slow, stable growth, so P/E ratios tend to be on the lower side).
• Consumer goods. 15–25 (depending on the company's growth potential and market demand).

Comparing a company's P/E ratio to its industry peers is a better way to determine if it's overvalued or undervalued. For example, a bank with a P/E ratio of 30 might be considered overvalued, while a tech company with the same ratio could be seen as having strong growth potential.

Determining overvaluation or undervaluation

By comparing a company's P/E ratio to its industry and historical averages, you can get an idea of whether it's overpriced or underpriced.

For example, if a company in the tech sector has a P/E ratio of 50 while the average for the sector is 25, it could be overvalued unless it has extraordinary growth potential. Similarly, if a stock's P/E ratio is significantly below its peers, it might be undervalued, making it a potential bargain—although it's important to investigate why.

The P/E ratio in action: Two examples

Understanding how the P/E ratio works in real-world scenarios can make it easier to interpret the numbers when evaluating stocks.

Here are examples of two popular and well-known companies:

1. High P/E stock example: Tesla

Tesla is known for its rapid growth, and its P/E ratio reflects this. As of September 2024, Tesla's P/E ratio stands at 71.4, which is relatively high compared to other sectors. This high ratio indicates that investors expect significant future growth.

Tesla's position in the electric vehicle market, coupled with its innovation in energy solutions, keeps its stock trading at a premium relative to its earnings.

2. Low P/E stock example: Ford

Ford, a more traditional automaker, has a much lower P/E ratio, reflecting its stable, slower growth trajectory. As of September 2024, Ford's P/E ratio is 11.40. This lower ratio suggests that Ford is more of a value stock, meaning it might be undervalued by the market.

Investors generally expect less aggressive growth compared to companies like Tesla, but Ford's established market presence offers stability and consistent dividends, making it attractive to certain types of investors.

Limitations of the P/E ratio

While the P/E ratio is a valuable tool for evaluating a stock, it has limitations that can lead to misleading conclusions if not used carefully. Here are a few to keep in mind:

Growth rates and the PEG ratio

The P/E ratio does not account for a company's growth potential, which can make it less useful for comparing growth stocks. That's where the PEG (Price/Earnings-to-Growth) ratio comes in. The PEG ratio adjusts the P/E ratio to account for the company's expected earnings growth.

Formula:

PEG ratio = P/E ratio / Growth rate

Example:

For instance, a high P/E ratio might seem off-putting, but if the company has a high growth rate, its PEG ratio may still indicate that the stock is fairly priced. The PEG ratio is especially useful for evaluating fast-growing sectors like technology, where high P/E ratios are common.

Negative P/E ratio

If a company reports negative earnings, its P/E ratio becomes negative or undefined. A negative P/E ratio typically means that the company is losing money, which can make it challenging to use this metric for valuation. In such cases, it's better to look at other financial indicators like cash flow or future earnings potential.

Earnings manipulation

A basic limitation of the P/E ratio is that it relies on earnings, which can sometimes be manipulated through accounting practices.

For example, companies might use creative accounting to boost their reported earnings temporarily, making their P/E ratio look better than it really is. This manipulation can distort the P/E ratio, leading to an overvaluation or undervaluation of the stock.

Conclusion: Making sense of the P/E ratio

The P/E ratio is a great starting point when evaluating whether a stock is priced fairly. It gives you a snapshot of how the market views a company's future—whether investors are paying a premium due to expected growth, or if the stock is priced low due to limited expectations.

However, the P/E ratio is just one tool. A high P/E for a fast-growing company doesn't necessarily mean it's overpriced, and a low P/E doesn't automatically signal a bargain. It's essential to look deeper, understand what is driving the numbers, and consider other metrics like the PEG ratio for a more complete assessment.

Ultimately, the P/E ratio is helpful, but it's crucial to examine the company as a whole, its growth potential, and the industry landscape to ensure you're making a smart investment move.