What is the Price-to-Earnings Ratio (P/E)?
The price-to-earnings ratio (P/E) is a valuation method used to compare a company’s current share price to its per-share earnings.
How Does the Price-to-Earnings Ratio (P/E) Work?
The market value per share is the current trading price for one share in a company, a relatively straightforward definition. However, earnings per share (EPS) may not be as intuitive for most investors. The more traditional and widely used version of the EPS calculation comes from the previous four quarters of the price-to-earnings ratio, called a trailing P/E. Another variation of the EPS can be calculated using a forward P/E, estimating the earnings for the upcoming four quarters. Both sides have their advantages, with the trailing P/E approach using actual data and the forward P/E predicting possible outcomes for the stock. Calculated as the following;
Price-to-Earnings Ratio (P/E) = Market value per share / Earnings Per Share (EPS)
Moving on from the basics, let us do a sample calculation with company XYZ that currently trades at $100.00 and has an earnings per share (EPS) of $5.00. Using the previously mentioned formula, you can calculate that XYZ’s price-to-earnings ratio is 100 / 5 = 20.
[See extra examples and learn more about how to use the P/E ratio in The Most Famous Number in Investing]
Why Does the Price-to-Earnings Ratio (P/E) Matter?
The price-to-earnings ratio is a powerful, but limited tool. For investors, it allows a very quick snapshot of the company’s finances without getting bogged down in the details of an accounting report.
Let us use our previous example of XYZ, and compare it to another company, ABC. Company XYZ has a P/E of 20, while company ABC has a P/E of 10. Company XYZ has the highest P/E ratio of the two and this would lead most investors to expect higher earnings in the future than from company ABC (which possesses a lower P/E ratio).
As noted earlier, the P/E ratio is limited. It does not paint the entire picture for the potential investor; rather it is a complementary tool in your financial toolbox. Be wary of forward EPS measures, (remember, EPS is an essential aspect of calculation of the P/E ratio) as they are matters of prediction and are only estimates of projected earnings. Further, trailing P/E ratios can only tell you what happened to a company in the previous time periods.
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.
Read This Next
Gift cards have surpassed all other categories as the most popular gift, according to the National Retail Federation. Here's a news flash, however: If this is the extent of your gift card...Read More →
You can elect to buy more stock with it, adding to your...Read More →
A sharp plunge on Monday, a stunning rebound Tuesday, another pullback Wednesday. When will it all end? It's increasingly clear that very low...Read More →