The price-to-earnings ratio is a way to measure how much value a stock offers. When we invest our dollars, we want to buy low and sell high, right? We want the cheap stuff that the market is currently undervaluing. Like finding an amazing designer jacket at a thrift shop and buying it for ten dollars.

We can figure out how the market values stocks by calculating a stock’s P/E ratio (or looking it up on the internet #lazy). It’s a key ratio that can give us a clue about the company’s overall value and growth potential.

The P/E ratio tells us the relationship between a company’s stock price and its earnings per share. P is for price and E is for earnings (per share).

Earnings per share, or EPS, takes the total company earnings and divides it by all the shares of stock the company has issued.

To get the P/E ratio, we divide the current price of the stock by the EPS.

But once we calculate it, what does this number tell us? Let’s take an example.

Price-to-Earnings Ratio Example

Today, Dog-Cat Company stock costs $10. Their earnings over the last 12 months were $1 million, and they have 1 million shares outstanding.

First, we calculate EPS:

EPS: $1 million earnings / 1 million shares = $1 per share

P/E ratio: $10 / $1 = 10

So for $1 of earnings for each share, the buyer of Dog-Cat would pay $10. Or, to look at it another way, investors are willing to pay $10 to get $1 of Dog-Cat earnings.

Basically, the P/E ratio tells us how the market’s value of the company (aka stock price) compares to how much money the company is actually making (earnings).

If most investors agree on a company’s growth potential (like not making much money now, but expected to make more in the future), the P/E ratio will likely be higher.

For companies earning negative dollars, no P/E ratio for you. We round up the negative earnings to zero and remember, as math class taught us, that you “CANNOT DIVIDE BY ZERO,” quoted from your TI-84 graphing calculator circa junior year precalc.

There are two types of P/E ratios: trailing and forward. When you use Yahoo Finance or other sites to look up a stock you’re researching, you’ll see trailing and forward P/E listed.

Let’s chat about what these are.

Trailing Price-to-Earnings

If you’re trailing someone, you’re looking at their back. Samesies with trailing P/E ratio. You’re looking at the ratio from the past.

The trailing P/E ratio uses the current stock price divided by the EPS, using the earnings from the last 12 months.

Last 12 months = past

Past = trailing

Trailing P/E ratio tells us the P/E ratio that’s already happened. In the Dog-Cat example above, we’re calculating the trailing P/E ratio.

Forward Price-to-Earnings

Just like trailing is in the past, forward-thinking means looking ahead, towards the future.

Repeat after me: Who can predict the future?

No one can!

But peeps be making some great guesses.

That’s the basis for the forward P/E ratio. It uses an EPS based on what’s predicted or estimated to be the company’s earnings.

In many cases, companies will provide investors estimates of their future earnings during quarterly investor calls or when releasing their quarterly financial reports.

Financial analysts will also add their own predictions to the earnings estimate soup. These numbers might vary from what the company predicts. You might see two different forward P/E ratios for the same company. Try to figure out where the data for the earnings estimate and stock price is coming from.

And always remember, the Forward P/E ratio is ultimately just professionals making their best guess. Sometimes they are even being guided by the company on their guess. Bias…is real.

What the P/E Ratio Tells Us

P/E ratios indicate a stock’s value. They tell us how much investors are willing to pay for $1 of company earnings.

We like P/E ratios because they make it easy to compare the value of different companies’ stock prices. Let’s say we have two companies that both make sneakers: Company A and Company B. If Company A has a higher stock price but a lower P/E ratio than Company B, that’s a sign Company A might be overvalued or Company B might be undervalued. Or it could mean Company A has more growth potential than Company B.

With the P/E ratio, we have a jumping-off point. We’d need to investigate both companies further to decide Company A and B’s growth and proper value.

How to Put P/E Ratios in Context

What is a “good” price-to-earnings ratio? Like any investing tool or ratio, you have to look at it in context to other factors. Investors often look at P/E ratios in context with:

Its PEG Ratio

PEG stands for Price-to-Earnings-Growth Ratio. You calculate it by dividing the P/E ratio by a company’s expected earnings growth rate.

Example time: Investors believe Dog-Cat Company EPS will grow 20% over the next year. So, given a P/E ratio of 10, Dog-Cat’s PEG ratio is:

10/20 = 0.5

The logic of the PEG ratio is that if a company’s growth rate equals its P/E ratio, investors are valuing it fully and fairly. That means a PEG ratio of 1 means spot-on valuation.

In the case of Dog-Cat company, the growth rate is higher than the P/E ratio, which gives us a PEG of less than 1. This potentially means the stock is selling for less than you would expect given its expected earnings growth rate. We like this because it means the stock is potentially being undervalued.

When a PEG ratio is over one, it could indicate the company is overvalued.

The caveat with the PEG ratio is that expected earnings growth can wildly differ depending on the source you use. Again, remember that when it comes to predicting the future, it’s all just guesswork.

Comparable Companies

Another way to analyze a stock’s P/E ratio is by comparing it to similar companies in the same industry.

Looking at a consumer good’s stock? Compare it to other consumer goods.

Looking at Netflix (NFLX)? Try comparing its P/E ratio to other streaming services like Apple (AAPL), Amazon (AMZ), Disney (DIS), and AT&T (T) (who owns Warner Media that owns HBO).

You’ll notice in that list, all of those companies are diversified businesses that have other streams of income. Netflix is the only business that only relies solely on subscription revenue. So even with comps, you may have to take your P/E comparisons with a grain of salt.

The stock’s past performance

Another way to analyze a stock’s P/E ratio is to look at its past P/E ratios and stock performance.

In the case of Netflix (NFLX), you can see in this chart how its P/E ratio has done over time, compared to its stock price and earnings.

RECAP

• Price-to-earnings ratio = current stock price / earnings per share (EPS)
• Tells us how much investors will pay for $1 of company earnings
• Trailing P/E ratio uses EPS over the past 12 months
• Forward P/E ratio uses future earnings predictions
• High P/E indicates a company is a growth stock or potentially overvalued
• Low P/E could mean the stock is being undervalued or that the stock has limited growth potential
• Negative earnings (aka zero income) stocks don’t have P/E ratios