The price-to-earnings ratio (P/E ratio) is a tool for investors to understand how expensive a stock is compared to a dollar of profitability. It is the price per share of stock divided by the earnings per share. This is important for investing since it tells you how much you’re paying for each dollar of earnings. It is a popular ratio that investors use to help get an idea of the value of a company. Although, a company having a high or low PE ratio is not necessarily good or bad.
High P/E Ratio could mean:
- The company’s stock could be overvalued
- Investors getting excited and buy shares while company earnings remain steady
- Investors are willing to pay a higher price per share right now because of future growth expectations
Companies that have quick growth in revenues (as with many companies in the technology sector) tend to have P/E’s above 25.
Low P/E Ratio could mean:
- Investors losing confidence and selling shares while earning remain steady
- Company earnings grow quickly before investors notice and buy out shares
A P/E ratio of 15 is a decent average for many stocks and even the stock market as a whole.
A P/E below 10 could mean that a company is hurting financially and might not have great earning potential in the future.
Using the P/E Ratio
Looking at the P/E ratio of a stock by itself does not say much unless you compare it to historical records or other competitor’s P/E in the same industry.
Here are some ways you can use to P/E ratio to help provide insight into the value of a company.
Comparing the P/E Ratio to a Stock Market Index
Calculating the P/E ratio of a stock market index like the S&P 500 will provide you with insight on how expensive stocks are in the market in general. Since it will be based on a collection of major companies, it acts as sort of an average P/E ratio and acts as a good benchmark for the whole stock market. Comparing any single stock’s P/E to the S&P 500’s will let you know if the P/E is high or low.
Comparing the P/E Ratio to Historical Data of the Company
You can also gain powerful insights if you compare the P/E ratio of a company to the ratio in the past to see if there are any discrepancies. You may notice that the current P/E ratio of a company is 50+ but has had a constant 15-20 ratio in the past. This might tell you that the stock could be overvalued, or investors are excited about new growth and profits in the future.
Comparing the P/E Ratio to the Industry Average
You can understand how a company stacks up with the industry average by comparing the P/E values. For example, if you compare the P/E ratio for Exxon Mobil (XOM) to the gas/oil industry average, you could determine whether investors believe a company is going to turn up high profits as opposed to the competition.
Comparing the P/E ratio to another Company
You could simply compare the ratio to another company and determine which stock is more “expensive”. This can help you determine if you want to invest in one company vs. another and what other investors think about them.