The price-to-earnings ratio, or P/E ratio, helps you compare the price of a company’s stock to the earnings the company generates. This comparison helps you understand whether markets are overvaluing or undervaluing a stock.
The P/E ratio is a key tool to help you compare the valuations of individual stocks or entire stock indexes, such as the S&P 500. In this article, we’ll explore the P/E ratio in depth, learn how to calculate a P/E ratio, and understand how it can help you make sound investment decisions.
What Is the P/E Ratio?
The P/E ratio is derived by dividing the price of a stock by the stock’s earnings. Think of it this way: The market price of a stock tells you how much people are willing to pay to own the shares, but the P/E ratio tells you whether the price accurately reflects the company’s earnings potential, or it’s value over time.
If a company’s stock is trading at $100 per share, for example, and the company generates $4 per share in annual earnings, the P/E ratio of the company’s stock would be 25 (100 / 4). To put it another way, given the company’s current earnings, it would take 25 years of accumulated earnings to equal the cost of the investment.
In addition to stocks, the P/E ratio is calculated for entire stock indexes. For example, the P/E ratio of the S&P 500 currently stands at 28.61. Since prices fluctuate constantly, the P/E ratio of stocks and stock indexes never stand still. The P/E ratio also changes as companies report earnings, typically on a quarterly basis.
Three Variants of the P/E Ratio
While the math behind the P/E ratio is straightforward—price divided by earnings—there are several ways to factor the price or earnings used for the calculation.
The price-to-earnings ratio is most commonly calculated using the current price of a stock, although one can use an average price over a set period of time. When it comes to the earnings part of the calculation, however, there are three varying approaches to the P/E ratio, each of which tell you different things about a stock.
Trailing Twelve Month (TTM) Earnings
One way to calculate the P/E ratio is to use a company’s earnings over the past 12 months. This is referred to as the trailing P/E ratio, or trailing twelve month earnings (TTM). Factoring in past earnings has the benefit of using actual, reported data, and this approach is widely used in the evaluation of companies.
Many financial websites, such as Google Finance and Yahoo! Finance, use the trailing P/E ratio. Popular investment apps M1 Finance and Robinhood use TTM earnings as well. For example, each of these sites recently reported the P/E ratio of Apple at about 33 (as of early August 2020).
The price-to-earnings ratio can also be calculated using an estimate of a company’s future earnings. While the forward P/E ratio, as it’s called, doesn’t benefit from reported data, it has the benefit of using the best available information of how the market expects a company to perform over the coming year.
Morningstar uses this method, which it calls Consensus Forward PE. Using this method, Morningstar calculates Apple’s PE at about 28 (as of early August 2020).
The Shiller P/E Ratio
A third approach is to use average earnings over a period of time. The most well known example of this approach is the Shiller P/E ratio, also known as the CAP/E ratio (cyclically adjusted price earnings ratio).
The Shiller PE is calculated by dividing the price by the average earnings over the past ten years, adjusted for inflation. It’s widely used to measure the valuation of the S&P 500 index. The Shiller PE of the S&P 500 currently stands at just over 30 (as of early August 2020).
How to Use the P/E Ratio
The most common use of the P/E ratio is to gauge the valuation of a stock or index. The higher the ratio, the more expensive a stock is relative to its earnings. The lower the ratio, the less expensive the stock.
In this way, stocks and equity mutual funds can be classified as “growth” or “value” investments. An investment with an above average price-to-earnings ratio, for example, might be classified as a growth investment. Amazon, with a PE currently at about 123, is an example of a growth company. An investment with a below-average P/E ratio would be classified as a value investment. Citigroup, with a price-to-earnings ratio under 9, would be considered a value company.
The P/E ratio can be used to compare two or more companies. This can be useful given that a company’s stock price, in and of itself, tells you nothing about the company’s overall valuation. Further, comparing one company’s stock price with another company’s stock price tells an investor nothing about their relative value as an investment.
P/E Ratio and Future Stock Returns
While the P/E ratio is frequently used to measure a company’s value, its ability to predict future returns is a matter of debate. The P/E ratio is not a sound indicator of the short-term price movements of a stock or index. There is some evidence, however, of an inverse correlation between the P/E ratio of the S&P 500 and future returns.
Some studies show that an above-average Shiller P/E ratio suggests lower stock market returns over the following 10 years. A recent study found that the Shiller PE was a reliable predictor of market returns between 1995 and 2020. In contrast, a recent Vanguard study found that the Shiller PE and other P/E ratio measures “had little or no correlation with future stock returns.”
P/E Ratio vs. Earnings Yield
The P/E ratio is closely related to earnings yield. Where the P/E ratio is calculated by dividing the price of a stock by its earnings, the earnings yield is calculated by dividing the earnings of a stock by a stock’s current price. It expresses earnings as a percentage of a stock’s price.
The earnings yield is often compared to current bond interest rates. Referred to by the acronym BEER (bond equity earnings yield ratio), this ratio shows the relationship between bond yields and earnings yields. Some studies suggest that it is a reliable indicator of stock price movements over the short-term.
What Is the PEG Ratio?
The PEG Ratio is also related to the P/E ratio in important ways. Calculated by dividing the P/E ratio by the anticipated growth rate of a stock, the PEG Ratio evaluates a company’s value based on both its current earnings and its future growth prospects.
In this way, some believe that the PEG Ratio is a more accurate measure of value than the P/E ratio. Like the forward P/E ratio, however, it is based on future growth estimates, which may not materialize.