Understanding the P/E Ratio

Two stocks. One costs $50 a share, the other $200. Which is the expensive one?

As price vs. value showed, the share price alone leaves out what you get. Attach annual profit to each quote and the comparison changes.

P/E is the number that fixes this. It sits on almost every stock page, takes a minute to learn, and once you can read it you can:

• Compare similar companies on earnings, whatever their share prices.
• See what the market expects. A high P/E can mean investors are betting on growth, or that earnings are temporarily depressed. A low one can mean expectations are low.
• Notice when a price has run ahead of the business — and when a cheap-looking stock is cheap for a reason.

What P/E is

P/E is short for price-to-earnings. It is the share price divided by the company's earnings per share — the annual profit split across every share.

Say a share costs $100 and the company earns $5 per share in a year. Its P/E is 20.

Read that as a price tag: you are paying $20 for every $1 of profit the company makes in a year. If earnings stay flat, the company would earn $100 per share over 20 years. You own a claim on those profits; they are not cash in your pocket.

Now the two stocks from a moment ago:

Company B costs four times as much per share, and it is the cheaper of the two. Every dollar of its profit costs half as much.

Trailing or forward

A trailing P/E uses reported earnings over the last twelve months. A forward P/E uses forecast earnings for a named period, such as the next fiscal year or the next twelve months. Higher forecast EPS gives a lower P/E at the same price, provided both use the same earnings definition. Check the field's label before comparing.

What counts as high or low

There is no line where cheap turns into expensive, but two reference points help.

• The comparison period matters. A market's historical average depends on the years and earnings measure you choose. An old average is not a permanent fair price.
• The business matters. Different growth prospects and risks can support different multiples. High in one industry can be ordinary in another.

The number itself is neither good nor bad. It is what other investors are willing to pay, which makes it a statement about the future — a high P/E often reflects a bet that profits will grow into it. Treat it as a question rather than an answer: this is what the market believes, and you get to decide whether you agree.

How to use it

A P/E tells you the price of earnings. Judging that price needs context, and there are three comparisons worth making.

1. Against the company's own past. Where does today's number sit against the last few years? A stock at 35 that normally trades at 25 is priced for something new. Find out what.
2. Against its competitors. Start inside the same industry, then compare growth, debt and earning power. A shared industry label does not make two businesses equally valuable.
3. Against its growth. A P/E of 30 can look more reasonable for a company growing profits 30% a year than one growing 5%. The PEG ratio makes that comparison, but how long growth lasts and how risky it is matter too.

A gap can reflect faster growth, a stronger balance sheet, a scandal or a fading business. Investigate the gap first. Then decide whether the evidence supports the premium or discount.

When P/E misleads

P/E breaks in a few predictable places. Knowing them keeps you out of most of the traps.

• The company is losing money. A negative P/E cannot usefully rank bargains, so screens show "NM" or a dash instead. At zero earnings, division is impossible.
• The year was unusual. A one-off asset sale or write-off can inflate or wreck a single year's profit, and the P/E with it. Look at several years at once.
• The business runs in cycles. Steel, cars, oil, chips — profits peak, the P/E looks low, and then profits fall. A low P/E on peak profits is a warning, not a bargain.

In short

• P/E is what you pay for one dollar of a company's annual profit.
• It puts similar companies on an earnings basis, whatever their shares cost.
• High often means high expectations, low often means low ones. Neither is good or bad on its own.
• It only means something next to a comparison: the company's past, its competitors, its growth.
• Set it aside for losses; question whether unusual or peak earnings can last.