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\n\nThe price-to-earnings ratio (P/E) is one of the most widely used metrics for investors and analysts to determine stock valuation. It shows whether a company's stock price is overvalued or undervalued and can reveal how a stock's valuation compares to its industry group or a benchmark like the S&P 500 index. A good P/E for one group or sector could be a poor P/E for another sector so comparisons should compare similar companies.\n
\n\n\nThe P/E ratio helps investors determine\u00a0the market value of a stock as compared to the company's earnings. It shows what the market is willing to pay for a stock based on its past or future earnings.\n
\n\n\nKey Takeaways
\n- The P/E ratio is calculated by dividing the market value price per share by the company's earnings per share.
- A high P/E ratio can mean that a stock's price is high relative to earnings and possibly overvalued.
- A low P/E ratio might indicate that the current stock price is low relative to earnings.\u00a0
- An investor could look for stocks within an industry\u00a0that is expected to benefit from the economic cycle and find companies with the lowest P/Es to determine which stocks are the most undervalued.
What Is a P/E Ratio?
\n\nCompanies that grow faster than average, such as technology companies, typically have higher P/Es. A\u00a0higher P/E ratio shows\u00a0that investors are willing to pay a higher share price now due to growth expectations in the future.\u00a0The median P/E for the S&P 500 was 14.93 as of May 2023.
\n
\nInvestors not only use\u00a0the P/E ratio to determine a\u00a0stock's market value\u00a0but also in determining\u00a0future\u00a0earnings growth. Investors might expect the company to\u00a0increase its dividends\u00a0as a result if earnings are\u00a0expected to rise. Higher earnings and rising dividends\u00a0typically lead\u00a0to a higher stock price.\n
\n\nFormula and Calculation of the P/E Ratio
\n\nThe P/E ratio is calculated by dividing the stock's current price by its latest earnings per share: Current price / most recent earnings per share = P/E ratio.
\n
\nEarnings per share (EPS) is the amount of a company's profit allocated to each outstanding share of a company's common stock. It serves as an indicator of the company\u2019s financial health. Earnings per share is the portion of a company's net income that would be earned per share if all profits were paid out to its shareholders. EPS is typically used by analysts and traders to establish the financial strength of a company. EPS provides the \u201cE\u201d or earnings portion of the P/E valuation ratio.\n
\n\nAnalyzing P/E Ratios
\n\nA stock should be compared to other stocks in its sector or industry group to determine whether\u00a0it's overvalued\u00a0or\u00a0undervalued.\n
\n\n\nAn industry group will benefit during a particular phase of the business cycle in most cases, so many professional investors will concentrate on an industry group when their turn in the cycle is up. Remember that the P/E is a measure of expected earnings. Inflation tends to rise as economies mature. The Federal Reserve increases interest rates as a result to slow the economy and tame inflation to prevent a rapid rise in prices. \n
\n\n\nCertain industries do well in this environment. Banks earn more income as interest\u00a0rates rise because they can charge higher rates on their credit\u00a0products such as credit cards and mortgages. Basic materials and energy companies also receive a boost in earnings from\u00a0inflation because they can charge higher prices for the commodities they harvest.\n
\n\n\nInterest rates will typically be low and banks tend to earn less revenue toward the end of an economic recession. But consumer cyclical stocks often have higher earnings because consumers may be more willing to purchase on credit when rates are low.\n
\n\nLimitations to the P/E Ratio
\n\nThe first part of the P/E equation or price is straightforward because the current market price of a stock is easily obtained, but determining an appropriate earnings number can be more difficult. Investors must determine how to define earnings and the factors that impact earnings. There are some limitations to the P/E ratio as a result as certain factors impact the P/E of a company.\n
\n\nVolatile Market Prices
\n\nVolatile market prices can throw off the P/E ratio, but this more commonly happens in the short term.\u00a0\n
\n\nEarnings Makeup of a Company
\n\nThe earnings makeup of a company is often difficult to determine. The P/E is typically\u00a0calculated by measuring historical earnings or trailing earnings, but historical earnings\u00a0aren't of much use to investors because they reveal little about future earnings.\n
\n\nInvestors are most interested in\u00a0determining future earnings.
\nForward earnings or future earnings are based on the opinions of Wall Street analysts, and they can be overly optimistic in their assumptions during periods of economic expansion. They can be overly pessimistic during times of economic contraction.\n
\n\n\nOne-time adjustments such as the\u00a0sale of a subsidiary\u00a0could inflate\u00a0earnings in the short term. This complicates the predictions of future earnings because the influx of cash from the sale\u00a0wouldn't be a sustainable contributor to earnings in the long\u00a0term.\u00a0Forward earnings can be useful, but they're prone to inaccuracies.\n
\n\nEarnings Growth
\n\nEarnings growth isn't included in the P/E ratio. The biggest limitation of the P/E ratio is that it tells investors little about the company's EPS growth prospects. An investor might be comfortable buying in at a high P/E ratio expecting earnings growth to bring the P/E back down to a lower level if the company is growing quickly. But they might look elsewhere for a stock with a lower P/E if earnings aren't growing quickly enough.\n
\n\n\nIt can be difficult to tell if a high P/E multiple is the result of expected growth or if the stock is simply overvalued.\n
\n\nThe PEG Ratio
\n\nA P/E ratio doesn't always show whether the P/E is appropriate for a company's forecasted growth rate even when it's calculated using a forward earnings estimate. Investors turn to another ratio known as the PEG ratio to address this limitation.\n
\n\nThe PEG ratio measures the relationship between the price/earnings ratio and earnings growth\u00a0to provide investors with a more complete story than the P/E alone.
\nThe PEG ratio allows investors\u00a0to calculate whether a stock's price\u00a0is\u00a0overvalued or undervalued\u00a0by analyzing both\u00a0today's earnings and the expected\u00a0growth rate for the company in the future.\n
\n\nExample of a PEG Ratio
\n\nAn advantage of using the PEG ratio is that you can compare the relative valuations of different industries that may have very different prevailing P/E ratios. This facilitates the comparison of different industries that each tend to each have their own historical P/E ranges. Here's a comparison of the relative valuation of a biotech stock and an integrated oil company.\n
\n\n| \u00a0 | \nBiotech Stock ABC\u00a0 | \nOil Stock XYZ\u00a0 | \n
| Current P/E | \n35 times earnings | \n16 times earnings | \n
| Five-year projected growth rate | \n25% | \n15% | \n
| PEG | \n35/25, or 1.40 | \n16/15, or 1.07 | \n
\nThese two fictional companies have very different valuations and growth rates, but the PEG ratio gives an apples-to-apples comparison of the relative valuations. The PEG ratio of the S&P 500 would be 16 / 12 = 1.33 if the S&P 500 had a current P/E ratio of 16 times trailing earnings and if the average analyst estimate for future earnings growth in the S&P 500 is 12% over the next five years,\n
\n\nWhat Does It Mean When a Company Has a High P/E Ratio?
\nA company with a current P/E ratio of 25, which is above the S&P\u00a0average, trades at 25 times its earnings. The high multiple indicates\u00a0that investors expect higher growth from the company compared to the overall\u00a0market. A high P/E does not necessarily mean a\u00a0stock is overvalued. Any\u00a0P/E ratio should be considered against the backdrop of the P/E for the company's\u00a0industry.
What Is a Sector?
\nA sector is\u00a0a general segment of the economy that contains similar industries. Sectors are made up of industry groups, and industry groups are made up of stocks with similar businesses such as banking or financial services.
What Is a Relative Valuation?
\n\nThe Bottom Line
\n\nThe price to earnings ratio (P/E) is one of the most common ratios used by investors to determine if\u00a0a company's stock price is valued properly relative to its earnings. The P/E ratio is popular and easy to calculate, but it has shortcomings that investors should consider when using it to determine a stock's valuation.\u00a0\n
\n\n\nThe P/E ratio doesn't factor in future earnings growth, so the PEG ratio provides more insight into\u00a0a stock's valuation. The PEG is a valuable tool for investors in\u00a0calculating\u00a0a stock's future prospects because it provides a forward-looking perspective. But no single ratio can tell investors all they need to know about a stock. It's important to use a variety of ratios to arrive at\u00a0a complete picture of a company's financial health\u00a0and its stock valuation.\n
\n\n\nEvery investor wants an edge in predicting a company's future, but a company's earnings guidance statements may not be a reliable source.\n
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+ "page_last_modified": " Wed, 28 Feb 2024 15:43:56 GMT"
+ }
+ ]
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