Price-to-Earnings Ratio: What Does It Mean and How to Calculate It?

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Tommy Syrmolotov
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December 1, 2021

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A stock's price-to-earnings ratio shows the relationship between the price of a stock and a company’s earnings. As investors, knowing the P/E ratio of stocks can prepare us for income expectations. Stocks with high prices simply indicate that investors are willing to pay more for their dividend expectations from the stock or the company. The price to earnings ratio formula is easy to use, and most of us can calculate it from financial statements. However, knowing what does P/E ratio mean is more important.

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What is P/E Ratio (Price-to-Earnings Ratio)?

The P/E ratio works by linking a company's stock market price and its earnings per issued share. The stock price earning ratio is calculated by dividing the current stock price by the company's earnings per share (EPS). If the EPS is not known, it can be calculated by finding out the company's revenue. This calculation can be done by deducting the company's paid dividends from its earnings for the year. This value is divided by the total shares outstanding.

How to interpret P/E ratio meaning is also essential. Questions like what is P/E ratio in stocks? What is a good P/E ratio for a stock? What is a good price to earnings ratio in an industry? These are all relevant questions. Having the answers can help to improve your portfolio management strategy.

The mainstream P/E valuation use is to assess the value of a stock or index. A low P/E ratio implies that the stock or an index is less expensive compared to its returns. The opposite also applies; a stock P/E ratio can be high, making it more costly than its earnings. Now how to use P/E ratio? Calculating P/E ratio allows investors to categorize investments. This is done by using the current P/E ratio of stocks and indexes and classifying them as growth or value investments. The decision to invest can depend on the individual trader's preference and trading strategy. 

A stock P/E ratio allows investors to see if the stock price or index is over- or undervalued. The ratio analysis of any stock may yield overpriced stocks or indexes, which is taken as a signal for growth stocks. Undervalued stocks are seen as value investments, meaning stocks that are expected to grow in the future, possibly over a long period of time.

Price-to-Earnings Ratio Formula

If you want to know how to calculate price earnings ratio, you can use the formula below:

p/e ratio formula equals stock price div by earnings per share - photo
Figure 1: PE Ratio Formula

The formula is fairly straightforward if you use a ratio calculator. Most screeners also show the pe stock price when showing details about the stock. You can see the P/E ratio for every recommended stock in Gainy. In case you need to know how to find price earnings ratio when the EPS is not known, you can follow these steps: 

  1. Find the share selling rate. Let's say it trades at $100 right now.
  2. Find out the earnings per share in the previous 12 months. If the EPS value is not given, it can be calculated by finding out the company's income. Assuming that the income for the year is $1.2 Million, and the company issued $200,000 of dividends. The revenue for the year is $ 1.2 Mn less the $ 0.2 Mn dividends paid. Net income works out to $1 Mn.
  3. Suppose shares in circulation are 100,000. Our earnings per share will be:

EPS = Income / Number of shares

EPS =  $ 1,000,000/100,000               

EPS = $10

  1. Now using the price/earnings ratio formula:

P/E Ratio = $100/10

P/E Ratio = $10

If you try the Gainy app, you'll see how easy it is to check the PE ratio for any stock.

Now that you know how to calculate PE ratio, what is PE ratio exactly? The PE ratio combines the number of shares, earnings, and share prices to let investors know how much they can earn from investing in a stock.

DELL Calculation Example: How to Calculate Price Earnings Ratio?

Table of Dell P/E ratios changing over time - photo
Figure 2. Dell’s P/E ratio next to share price and EPS

The table in Figure 2 above shows the stock prices and Net EPS for the trailing 12 months (TTM). The P/E ratio formula is applied: the stock price divided by the EPS gives the PE Ratio value.

For instance, the values for 31st July give the stock price of $96.62 and the EPS of $4.83.

Dividing 96.62 by 4.83 will give a forward pe ratio of 20. The same formula will apply to all values. All the stock prices divided by the EPS value will provide the P/E ratio for each unique value.

P/E Ratio Explained

Graphs link between stock price TTM and P/E ratio - photo
Figure 3. Dell’s Pricing Graphs

From Figure 3 above, you can see that the stock prices do not reflect declining EPS. In fact, in some areas, it seems like stock prices are higher where EPS is low. Similarly, the PE ratio graph is somewhat like the EPS graph. At the same time, the pe stock price chart doesn't match its dips and highs. This figure shows the inherent problem with the PE ratio.

What is a Good P/E Ratio for a Stock?

Now that we are aware of how to calculate the P/E ratio, we can try understanding how to interpret it. As we discussed earlier, investors see a share with a high P/E ratio as being more attractive. It also shows that buyers are okay with paying a higher amount for each share. This good price is acceptable because they foresee rapid growth and high profitability, and subsequently higher earnings.

To decide if a price/earnings ratio is on the higher or lower side, we have to assess it. This is done through comparison with the P/E ratios of peer firms operating in the same niches. For example, if one firm has a P/E of 10x, and a majority of peer companies have P/E ratios of 12x earnings, it is safe to say that the company you have picked is considered less valuable by the market.

On average, the P/E ratio for stocks ranges around the 20-25 mark. This ratio means that investors are willing to pay $20-$25 per $1 of company earnings. However, there are specific industries where that average P/E ratio can be much lower or much higher.

For instance, firms in traditionally high-growth categories like tech, biotech, e-commerce, and other high-growth sectors can have significantly larger P/E ratios than the stock market average. For example, Amazon (AMZN) has maintained a P/E ratio of approximately 60[1]. Compared with the average P/E ratio of the S&P 500 index of 15 makes the earnings from Amazon are much more expensive for investors.

From a portfolio management perspective, income from Amazon shares is much more expensive than other companies. Investors that look for value for their investment would not opt for Amazon shares because of its high P/E ratio.

The Drawbacks of Price-to-Earnings Ratio Calculation

While the P/E ratio is commonly used and well known for stock analysis by investors for portfolio selection, it has its limitations. From the Amazon example, the P/E of 60 signifies that its earnings are expensive. Suppose we look at just the P/E ratio. But if we look at the IPO offering price of $18 in 1997 and compare it with the current trading price, it suddenly seems to make sense to invest in the stock.

Since P/E ratios are by definition calculated from company earnings and average price, which can be inflated due to extraordinary income. They can also be deflated due to some one-off expenses, like a damages claim or project costs. These instances can skew the P/E ratio for some firms. Creative and diverse accounting approaches also affect the bottom line of a business’s income statements and may distort the P/E ratio as well.

A significant limitation of the P/E ratio is its reliance on past earnings. While the stock price changes daily, the earnings figures can be as old as three months since most companies report their earnings quarterly. This mismatch causes two problems: the first; the P/E ratio does not report concurrent income. The second is that the historical revenues do not guarantee success for any stock in the future.

This problem is overcome by some investors who feel that the price-to-earnings ratio (P/E) is a basic formula to gauge a stock's current value. They modify the formula to adjust it for its bias for historical prices. These investors compare two variations of the formula. One version compares the stock's price to the income in the past 12 months and the second version compares the cost to the projected earnings for the coming 12 months.

Final Thoughts

The P/E ratio links a stock's market rates with its earnings per issued share (EPS). The stock price earning ratio is obtained by dividing the latest stock rates by the firm’s earnings per share (EPS). If the EPS is not known,  it can be calculated by finding out its income. Income is calculated by subtracting the company's paid dividends from its earnings for the year. This value is divided by the total shares outstanding. Most screeners, including Gainy, have the option of showing the P/E ratio when showing details about the stock. 

On average, most stocks have a P/E ratio that is fifteen times higher than the earnings per share. This means that most stocks have a P/E ratio of 15x. If the P/E is above this benchmark, the stock is pricey, making it a growth stock. If the ratio is below this, the stock may be a good buy for value investment.

FAQ

How to find p/e ratio?

This ratio is estimated by dividing the market price of a company's share by its Earnings Per Share (EPS) to get the P/E ratio.

How to calculate price-to-earnings ratio?

For instance, if a company's share closed at $65 and EPS for the past 12 months averaged $9., its P/E ratio will work out to 7.22. This means that stockholders will spend $7.22 for every dollar of income.

What are the best P/E ratio stocks?

There isn’t a “best” P/E ratio simply because the P/E ratio is a comparative tool and doesn't give you a yes or no answer. There are few financial ratios that will. What you have to do is to do some homework. See what the other companies’ P/E ratios are, how their earnings and market prices are. You compare them with your target company and decide if it is worthwhile to invest. Another way to get some best P/E ratio stocks options is to decide if you want to opt for value or growth stocks, and then assess the stocks with the lower (or higher) P/E ratios so that you can finalize a list of stocks.

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