Understanding Price-to-Earnings Ratios

By Elizabeth Lavoie on June 21, 2024

There are many measures to value and compare investments, but the price-to-earnings or P/E ratio is probably the one most often referred to in financial commentary. As a result, you’ve likely heard the term and are familiar with it. But do you really know and understand what a P/E ratio is? Maybe you’ve contemplated asking your financial advisor but feel like you should already know. Regardless, let’s break it down and walk through why it’s so popular.

Simply put, a price-to-earnings ratio is the price of a stock or group of stocks divided by their earnings-per-share, or EPS. So, in the P/E ratio, the “P” is the stock’s price and the “E” is the stock’s earnings-per-share.

The price of a stock is easy to find but the earnings component is more complicated. Companies report their actual earnings on a quarterly basis and provide a forecast of what they expect to earn in the quarters and years ahead. Financial analysts also make forecasts of what they expect a company to earn. Furthermore, investment strategists do the same for markets or indices overall. Earnings forecasts may also be adjusted at any time when expectations change.

If one is attempting to value a company or index today, we use the current price, but one must also decide what type of earnings to use. For example, a P/E ratio can be calculated on a trailing basis or on a forward basis. A trailing basis simply means the price can be compared to how a company has performed in the past (a trailing P/E), or the price can be compared to how it is expected to perform in the future (a forward P/E). A forward P/E uses earnings estimates, which are forecast by stock analysts as well as provided by the companies themselves. Alternatively, a trailing P/E uses a company’s past or actual earnings. Valuations can differ dramatically depending on which ratio is used.

Another popular valuation method is the Shiller or CAPE P/E (Cyclically Adjusted P/E), which takes the current price and divides it by the average 10-year inflation-adjusted earnings. Since economic or other market-moving events can affect prices and earnings in the short term, the Shiller P/E can be a more appropriate valuation for longer-term investors as it smooths out volatility. Unlike a regular P/E ratio, the Shiller P/E is generally applied to an index (i.e. the market) rather than to individual stocks.

In summary, a P/E ratio is a tool that can be used to value and compare a company, index, or even sector of the market. Furthermore, it can help reveal if something might be over/undervalued or if the price is higher or lower than one might expect given its profitability. That said, stocks can continue to trade at P/E values that are over or undervalued for extended periods of time and go well beyond average levels or expectations. For example, during the dotcom bubble the index P/Es were at much higher levels than today with the Nasdaq at 200 times earnings and the S&P 500 at 45 times earnings. Therefore, considering other factors when choosing an investment is very important.

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