What is the price to earnings ratio

The price-to-earnings ratio is a key metric used by investors and traders to assess whether a company’s share price is over or undervalued. Learn how to use the P/E ratio in your fundamental analysis.

• What is the P/E ratio?
• What does the P/E ratio indicate?
• P/E ratio formula
• Absolute P/E ratio vs relative P/E ratio
• What is a good P/E ratio?
• What is a high P/E ratio?
• What is a low P/E ratio?
• P/E ratio example: Tesla P/E ratio
• Criticisms of the P/E ratio
• The P/E ratio summed up

What is the P/E ratio?

The price-to-earnings ratio (P/E) ratio shows how a company’s share price compares to its earnings per share (EPS). While the former shows us how much someone is willing to pay for a share, the P/E ratio tells us whether that accurately reflects the intrinsic value of the share and the company’s balance sheet.

EPS shows how much each shareholder would earn if the company’s profits were paid out to them, so the P/E ratio indicates how far a company’s shares are trading above its financial return. For example, a P/E ratio of 10 means a company’s share price is 10x its earnings.

Earnings and the P/E ratio give investors key insights into how profitable a company is, what its growth journey has looked like and what its future could be.

What does the P/E ratio indicate?

The P/E ratio indicates how much market participants are willing to pay for a stock based on its earnings.

A high P/E ratio is an indication that a stock’s price is high compared to previous or current earnings, which could mean it’s overvalued. A low P/E ratio shows the opposite, that a company’s current share price is low compared to its earnings.

P/E ratio formula

To calculate a company’s P/E ratio, you divide the market value of its shares by its earnings per share. The equation is:

P/E ratio = share price/earnings per share

Absolute P/E ratio vs relative P/E ratio

Some analysts make the distinction between absolute and relative P/E ratios. The absolute P/E is the standard calculation shown above, while the relative P/E takes this figure and compares it to a benchmark or the company’s historic P/E ratio over a longer period.

So, say a company's P/E over the last 10 years has ranged between 10 and 25. If the current (absolute) P/E ratio is 20, the relative P/E for the highest historic value of this past range is 0.8 (20/25), and the current P/E relative to the low end of the range is 2 (20/10).

What is a good P/E ratio?

A good P/E ratio is completely dependent on the stock you’re looking at and the average for the industry or stock market it sits in. For the S&P 500 that’s between 13 and 15. While the average P/E for the FTSE 100 is 15.34 as of October 2022.

What is a high P/E ratio?

A high P/E ratio is also a relative term, as there's no specific number that marks the point at which a stock is thought of as expensive. In general, stocks with P/E ratios of below 15 are considered cheap, while stocks above about 18 are thought of as overpriced.

But ultimately, whether a P/E ratio is high or low will depend on the industry it’s in.

Is a high P/E ratio good?

A high P/E ratio is often thought of as a good thing as it indicates a growth stock. The expectation of future growth means that investors are more willing to pay for them. While growth stocks are popular, their high volatility creates a risk.

However, a high P/E can also be an indicator that there’s not much space for a company to continue growing at the same pace. And once a company is unlikely to meet investor expectations, it’s considered overvalued and its share price is likely to fall to more reasonable levels.

US technology companies tend to have some of the highest P/E ratios on the stock market, due to the high level of growth expected from them. For example, in December 2022, Amazon had a P/E ratio of 83.5, while Apple had a P/E ratio of 24.19.

Discover more about overbought stocks

What is a low P/E ratio?

Typically, a P/E ratio below 15 is considered low, so the shares are labelled ‘cheap’, but as with a ‘high’ P/E ratio the point at which a stock is considered undervalued is subjective.

A low P/E ratio can vary across industries, so you’ll need to research what the average is.

Is a low P/E ratio good?

A low P/E ratio can be a good thing but it’s highly dependent on the stock in question. It can be an indication of an undervalued share, but it can also be a sign of poor accounting and low growth potential.

To separate the good from the bad, you’ll need to do a deep dive into a company’s earnings report and balance sheet to establish its growth outlook.

Find out how to read a company's earnings report

Low P/E ratios are very common among value stocks, which can have low share prices compared to their actual intrinsic value. Taking advantage of this discrepancy is a key investment strategy: buying shares when they’re cheap and taking advantage of the market correction.

For example, the FTSE 100 has a lower P/E ratio than the Nasdaq 100 – of 15 against 23 – because it’s comprised of more value shares compared to the high-growth stocks of the US tech sector.

Value stocks can be more appealing to investors as they tend to pay dividends, whereas growth stocks reinvest funds into the company. For example, FTSE-100 companies have a dividend yield of 4-6% compared to the 1.15% dividend yield of the Nasdaq 100.

Learn about how to find oversold stocks

P/E ratio example: Tesla P/E ratio

Tesla is known for having a high P/E ratio – as its share price is significantly above its potential earnings. This makes it a good example of traders paying for reputation and future outlook over current earnings.

Say Tesla’s EPS is 0.95 and its share price is trading at $174, this gives TSLA a P/E ratio of 515.78 , meaning Tesla shares are trading at 183.15 times its earnings.

While the main assumption could be that TSLA stock is overvalued and may experience short-term volatility, it’s also indicative that people are willing to pay above the odds to hold TSLA shares based on expectations for future profitability.

By comparing this figure to an industry benchmark, we can see if Tesla is trading above or below average. For example, if the US Auto sector on the S&P 500 has an average P/E ratio of 50.2, TSLA is trading well above the benchmark. 

See a history of Tesla's share price

Criticisms of the P/E ratio

While the P/E ratio is taken as a sign of whether or not a company’s stock price is over or undervalued, on its own it can’t tell us much.

Critics of the P/E ratio argue that it doesn’t look at cash earnings, but rather accounted earnings, the calculations for which can differ from company to company, and between countries, depending on the standard rules of accounting. 

Another large criticism is that it’s a completely theoretical assessment. There’s absolutely no guarantee that a company will achieve the earnings forecast created from the P/E ratio. Unpredictable events can happen that mean a company doesn’t reach its growth targets, and its earnings come in significantly lower than forecast. So, making decisions solely based on the P/E ratio can be unpredictable. But arguably, most financial ratios are supposed to act as guidance, not guarantees.

Finally, the P/E figure needs to be compared to a benchmark or historical P/E range of the company. There are variations of the P/E ratio that attempt to build on the usefulness of the original measurement – which we’ll cover later.

But ultimately, you should use other financial ratios in conjunction with the P/E ratio for a more comprehensive overview. For example, the price-to-book ratio compares stock price to book value, while the price-to-sales ratio compares stock price relative to revenue.

Learn more about financial ratio analysis

Types of P/E ratios

Variations of the P/E ratio have been developed over the years that give investors different insights into a company’s worth. Each uses a different timeframe of data to achieve a different outcome – some give leading projections, and others are lagging.

The most common P/E ratios are:

• Trailing price to earnings
• Forward price to earnings
• CAPE ratio

Trailing price-to-earnings ratio

When analysts are talking about the P/E ratio, they’re usually talking about the trailing price-to-earnings ratio. It’s the most used P/E metric because it’s based on actual performance data rather than estimates.

Unlike other metrics – such as the forward P/E, which we’ll look a next – it reflects the true financial performance of a company rather than the subjective opinions of market participants.

The trailing P/E is a relative valuation multiple that’s calculated by dividing the company’s current share price by the previous 12 months of earnings per share. The formula is:

Trailing P/E = current share price / historical EPS for the last 12 months

The downside to using the trailing P/E ratio is that financials can be impacted by different factors over time, so a company’s past performance doesn’t necessarily indicate future behaviour.

Forward price-to-earnings ratio

The forward price-to-earnings ratio is less commonly used than the trailing variation, as it relies on forward-looking earnings estimates. The forward P/E divides a company’s current price per share by its future earnings – projected over a 12-month period.

The formula is:

Forward P/E ratio = current share price / forecasted EPS over the next 12 months

The forward P/E can be useful for high-growth companies or younger companies that have less historic data to rely on. However, as estimates can be adjusted to make a company look more attractive to investors, the forward P/E should always be taken with a pinch of salt.

Cape ratio vs P/E ratio

The CAPE ratio is another variation of the P/E ratio, which uses EPS over a ten-year period to smooth out fluctuations in profits that could appear over the typical 12-month analysis. It’s based on the belief that the shorter timeframe is too volatile for accurate readings.

The CAPE ratio is calculated by dividing a company’s share price by the ten-year average of the company’s earnings, adjusted for inflation. The formula is:

CAPE = current share price / ten-year average of inflation-adjusted earnings

CAPE stands for cyclically adjusted price-to-earnings ratio and was coined by Yale University professor Robert Shiller.

While the P/E ratio is typically used to compare a stock to a competitor or benchmark, the CAPE ratio is used on broader equity indices, to determine whether the entire market is over or undervalued.

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The P/E ratio summed up

• The price-to-earnings ratio (P/E) ratio shows how the market value of a company’s shares compares to its earnings per share (EPS)
• It indicates how much market participants are willing to pay for a stock based on its earnings
• You calculate the P/E ratio by dividing the market value of a share by the company’s earnings per share
• A high P/E ratio – over 18 – is an indication that a stock’s price is high compared to previous or current earnings, which could mean its overvalued
• A low P/E ratio – under 15 – shows that a company’s current share price is low compared to its earnings
• Critics of the P/E ratio argue it can’t show much on its own, and needs to be compared to a benchmark or historic data
• Variations of the P/E ratio have been made to build on the usefulness of the basic P/E ratio
• The trailing P/E is a relative valuation multiple that’s calculated by dividing the company’s current share price by the previous 12 months of earnings per share
• The forward P/E divides a company’s current price per share by its future earnings – projected over a 12-month period
• The CAPE ratio uses EPS over a ten-year period to smooth out fluctuations in profits that could appear over the typical 12-month analysis