On a similar note...
On a similar note...
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A company’s price-to-earnings ratio, or PE ratio, is a single number that packs a lot of punch, and one of the most common ways to value a company’s stock shares. But what is it, and what makes it so important?
What is price-to-earnings ratio?
PE ratio compares a company’s current stock price to its earnings per share, or EPS, which can be calculated based on historical data or forward-looking estimates. It's a standard part of stock research investors use to:
Compare the stock prices of similar companies to find outliers.
Determine if the stock is undervalued, appropriately priced or overvalued.
Decide, based on its value, if they should buy, sell or hold any particular stock.
“PE ratio” may sound technical, but it’s really just a comparison of how the public feels about a company (its stock price) and how well the company is actually doing (its EPS).
PE ratio example
Here’s one scenario: A company posts stable profits quarter after quarter, and its projected profits are equally stable. If its stock price jumps but its earnings stay the same (and no earnings increases are expected), the company’s intrinsic value didn’t change; the market’s perception of the company did.
In this instance, the earnings in the PE ratio stayed the same, while the price soared, which mathematically sends the overall PE ratio higher. If a company’s PE ratio is significantly higher than its peers, there’s a chance the stock is overvalued.
Another way to understand PE ratio: It’s a measure of how much investors are paying for every $1 of a company’s earnings. Imagine two similar companies in the same sector. One has a share price of $100 and a PE ratio of 15. The other has a share price of $50 and a PE ratio of 30. The first company’s share price may be higher, but a PE ratio of 15 means you’re only paying $15 for every $1 of the company’s earnings. Investors in the company with a PE ratio of 30 are paying $30 for $1 of earnings.
How to calculate PE ratio
To arrive at a company’s PE ratio, you’ll need to first know its EPS, which is calculated by dividing the company’s net profits by the number of shares of common stock it has outstanding. Once you have that, you can divide the company’s current share price by its EPS.
For example, if a company has earnings of $10 billion and has 2 billion shares outstanding, its EPS is $5. If its stock price is currently $120, its PE ratio would be 120 divided by 5, which comes out to 24. One way to put it is that the stock is trading 24 times higher than the company’s earnings, or 24x.
Nerd tip: Just because you know how to calculate PE ratio doesn’t mean you have to. Online brokerages offer stock screening tools that tell you the PE ratio of a stock, along with many other helpful data points.
Want to get started? See NerdWallet’s list of the best online brokerages for stock trading
What’s a good PE ratio?
There’s no single “good” PE ratio because it’s a comparison tool, not a benchmark figure.
However, by comparing PE ratios, you can uncover a lot about a particular company. Below are a few examples of what certain PE ratios may tell you when compared to the ratios of other companies.
High PE ratio
The stock may be overvalued
As we touched on above, if a stock’s PE ratio is significantly higher than other similar companies — or even the company’s own historical PE ratio — there’s a chance the stock is overvalued.
For example, if companies in a particular sector have PE ratios between 15 and 25, and one company’s PE ratio jumps above 30, that could be an indicator the stock might be overvalued. Similarly, if a company’s PE ratio has hovered around 20 for a long period and rises to 45, this, too, could signal an overvalued stock. And when a stock is overvalued, it may mean it’s due for a correction.
Investors expect higher future earnings
A stock’s PE ratio can rise if investors believe future earnings will be higher than current levels, which is typically how “growth stocks” are defined. If a company unveils a new product or service, its stock price could rise on the excitement of the announcement, with the expectation that the new offering will drive higher earnings down the road.
In this instance, investors may buy in, or continue holding their investment, even if the stock appears to be overvalued.
Differentiating between overvalued stocks and growth stocks comes down to further analysis. Is the high PE ratio a symptom of market-driven hype? Or is there a better reason investors are anticipating higher future returns? These are questions you could ask to decide if it might be time to buy, sell or hold.
Low PE ratio
The stock may be undervalued
A low PE ratio may signal that the stock price doesn’t accurately reflect the true value of the company based on its earnings.
In this instance, the stock price may stay the same while the company’s earnings increase, which would send the PE ratio lower. Investors may see this as an opportunity to buy the stock with the expectation that the price will rise in the future to reflect the underlying earnings increase.
Low PE ratios are generally aligned with value stocks, as opposed to the growth stocks outlined above.
Company earnings may be inaccurate or could drop
This could occur if companies miss earnings targets, inflate or otherwise misrepresent their earnings or are in other kinds of financial trouble.
In this instance, investors may fear the stock price will remain depressed based on the company’s performance, without future growth prospects.
Discerning between undervalued stocks and potentially troublesome stocks comes down to further analysis and asking yourself questions similar to those listed above to differentiate between overvalued and growth stocks.
» Ready to start investing? Learn how to buy stocks.
The drawbacks of PE ratio analysis
It’s one of the most accepted maxims in the investing world: Past performance doesn’t guarantee future results. And this goes for EPS data, too.
EPS is typically based on historical data, which can be an indicator of a company’s future performance, but is by no means a guarantee. In some cases, a company’s PE ratio could fluctuate based on one-time gains or losses that don’t reflect sustained earnings. For businesses that are highly cyclical, a low PE ratio may signal an undervalued stock, when in reality, it’s been operating in a period of high earnings that’s about to end. An investor may buy in thinking they’re buying at a discount, only for earnings to drop soon after — possibly followed by the stock price.
Investors will also use what’s called forward PE ratio in their analysis. Instead of using past earnings data to generate EPS, this ratio uses the company’s own forward-looking guidance, which is the company’s prediction of how it will perform in the future.
While that’s based on thorough research and analysis, at the end of the day, it’s still a prediction. Moreover, companies that provide guidance in accordance with U.S. Securities and Exchange Commission law are protected from civil liability, shielding them from lawsuits filed by investors who bought stock based on forward-looking guidance that didn’t prove true.
In other words, when using forward PE to justify a stock purchase, it’s buyer beware.
For many investors, low-cost index funds or exchange-traded funds are the easiest way to invest in stocks. Generally speaking, no more than 10% of your portfolio should be allocated toward individual stocks. If you do decide to build a portfolio out of individual stocks, make sure you do so after thorough research, including the PE ratio analysis outlined above.