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\"InvestmentZen\"
Home \u00bb Investing \u00bb Stocks

What is a Good PE Ratio for a Stock? Is a High P/E Ratio Good or Bad?

What is a good PE ratio for a stock? Is a high PE ratio good or bad? We’ll dive into the nuances of this all-important stock investing ratio and how to put it in its industry and historical context

By Marshall Hargrave

Equity Analyst

9 Best Stock Screeners (Free & Paid) In 2024
\"stock
Stock Valuation Methods: How To Evaluate A Stock And Calculate Its Intrinsic Value

The price-to-earnings ratio (P/E ratio) is a valuation metric used by investors to get an idea of whether a stock is over- or undervalued. But understanding\u00a0what is a “good” P/E ratio for a stock requires additional context.

Let me explain.

P/E ratio alone isn’t useful. It’s best used as a relative metric i.e. when comparing P/E ratios between similar companies operating within the same industry. This is one of the most common types of fundamental analysis.

Is a High PE Ratio Good or Bad?

If you were wondering “Is a high PE ratio good?”, the short answer is “no”.

The higher the P/E ratio, the more you are paying for each dollar of earnings. This makes a high PE ratio bad for investors, strictly from a price to earnings perspective.

A higher P/E ratio means you are paying more to purchase a share of the company’s earnings.

So, what is a good PE ratio for a stock? A \u201cgood\u201d P/E ratio isn\u2019t necessarily a high ratio or a low ratio on its own.

The market average P/E ratio currently ranges from 20-25, so a higher PE above that could be considered bad, while a lower PE ratio could be considered better.

\"is

However, the long answer is more nuanced than that.

A high P/E ratio, whether compared to the industry average or its historical average, means you are paying more for each dollar of earnings, but it also implies that investors are expecting the company to grow earnings faster in the future, whether it be versus its competitors or its own past growth. Having someone to help you with these will be easier for you to comprehend. However, choosing a professional consultant to guide you with these will be difficult if you don’t understand the difference between an accountant and a bookkeeper.

P/E Ratios Are Only Useful Compared to a Benchmark

A P/E ratio of 10 might be pretty normal for a utility company, while it might be exceptionally low for a software business.

That\u2019s where the industry PE ratios come into play. What\u2019s the expectations of the company relative to its major peers and competitors?

That\u2019s a question that can be answered by comparing a company\u2019s P/E ratio to its industry or historical pe ratios.

A stock market index, such as the S&P 500, can be used to gauge whether the company is over- or undervalued relative to the market.

A P/E ratio can also be benchmarked relative to the industry average P/E, such as comparing McDonald\u2019s to the average P/E ratios of other fast food restaurants.

You can get industry P/E ratio data at WallStreetZen.com. Unlike most stock research websites that just show you P/E ratio as a single number, WallStreetZen shows you the average market P/E ratio, as well as the P/E ratio of the company you’re researching.

In this example from McDonalds (NYSE: MCD), we can see how comparing PE ratio with benchmarks helps us determine whether a PE ratio is relatively good or bad.

This chart from WallStreetZen shows us Mcdonald’s P/E ratio over time, compared to two important benchmarks – the US market P/E ratio average, and the US restaurant industry P/E ratio average.

What’s unique here is that WallStreetZen also runs automated due checks that compare McDonald’s P/E ratio with the US market average and the US Restaurant industry average, and gives you the results in simple, one-line explanations.

In the example above, we can see that Mcdonald’s is poor value relative to the U.S. market from a P/E perspective, but good value relative to the US Restaurant industry.

You can try heading over to WallStreetZen and searching for stock you’re interested in to see how its P/E ratio compares with the industry / market.

How Industry P/E Ratios Work

Industry PE ratios are the average (mean) P/E ratio of all the companies that operate within a certain industry.

For example, the industry P/E for US auto manufacturers would include the average P/E ratio of Ford (NYSE:F), General Motors (NYSE:GM) and Toyota (NYSE:TM), among many others.

If we were to look up the P/E ratio of Tesla (NASDAQ: TSLA), we would want to see how it compares to its peers.

In the example above, we can see that investors are willing to pay more per earnings per share for TSLA, compared to other US automobile manufacturers. If you view Tesla as a promising company disrupting the automobile industry that will continue to take market share from its competitors (like the folks at manufacturing.net), then paying a higher price may make sense.

However, if you’re a skeptic, you would view Tesla as grossly overvalued based on its high price to earnings ratio. It’s often the case that companies have more a reasonable P/E ratio when they first become public \u2014 if you love Tesla and Elon Musk, you may want to keep an eye on the return of Twitter stock to the public market.

Price To Earnings Tells You How Expensive a Stock Is, Relative To Other Stocks

Stock price alone has nothing to do with how \u201cexpensive\u201d a stock is\u2014shares of Booking Holdings (BKNG)\u2014owner of sites like Priceline and Booking.com\u2014trade for nearly $1,400.

However, it\u2019s not as expensive as other top travel website stocks. Booking Holdings has a P/E ratio of 12. Keep that in mind.

Meanwhile, shares of Expedia (EXPE) trade for less than $70 a piece. But its P/E ratio is 18. Then there\u2019s TripAdvisor (TRIP), which trades at $18 a share, yet has a P/E of over 20.

So, while you have to pay $1,400 to buy one share of Booking Holdings stock, you\u2019re effectively only paying $12 for $1 stake in the company’s earnings, given its P/E is 12. For TripAdvisor, you\u2019re paying $20 for a $1 earnings stake.

Now, the reason you\u2019re paying more for TripAdvisor is because investors believe it will grow earnings faster in the future.

The industry P/E ratio for Booking Holdings would include all its major peers and competitors. The travel and leisure industry P/E is roughly 19.

Based on Booking Holdings 12 P/E, the company is expected to grow its earnings at a rate below the travel and leisure industry. Whether that will happen or not is something you have to decide for yourself.

If you believe the market is missing something and that Booking Holdings is well positioned to take market share from a competitor then the stock could be considered \u201cundervalued.\u201d

Industry P/E Ratios for Individual Stocks

Different industries have different P/E ratios that are considered \u201cnormal.\u201d

For example, some industries trade at an average of 15 times earnings, while others trade at 30 times. It\u2019s because some industries have different expectations.

Utility companies tend to have lower P/E ratios given their low historical earnings. Meanwhile, technology companies have enjoyed higher P/E ratios due to their higher earnings growth.

Consider this, during the Great Recession technology stocks had lower P/E ratios than consumer staple stocks. That\u2019s because investors expected consumer staples, like toothpaste and groceries, were expected to outperform tech stocks in the near-term.

How to Calculate the P/E Ratio

The easy way to think about P/E ratio is\u2014it\u2019s what you\u2019d pay for $1 of a company\u2019s earnings. The formula for P/E ratio is:

Price-to-Earnings (P/E) Ratio = Stock Price / Earnings Per Share (EPS)

Most financial websites openly publish the P/E ratio, so you don’t have to calculate it from scratch. However, understanding where they are getting the numbers is always useful.

A P/E ratio includes a company\u2019s stock price, which can be found in any number of stock research websites. But when it comes to the earnings per share (EPS) part, some sites and sources use the trailing twelve months\u2019 (TTM) earnings, while others stick to the fiscal year\u2014which many times ends on Dec. 31, but can end on other dates.

So if a stock is trading for $20 a share and made $2 in EPS over the trailing twelve months, its P/E ratio is 10, ($20 / $2).

A company\u2019s earnings is its net income. Earnings per share (EPS) is the company\u2019s net income divided by its total shares outstanding. (Note for dividend investors: Earnings are calculated before dividend payments are distributed)

For example, to calculate Microsoft\u2019s P/E ratio, you\u2019d first need to calculate Microsoft\u2019s earnings per shares.

For the trailing twelve months (TTM), which is the four most recent quarters of reported financials, Microsoft has posted EPS of $5.36. Its shares outstanding is 7.673 billion. As of Apr. 25, 2020, Microsoft\u2019s stock price is $174.55.\u00a0\u00a0Thus, its P/E ratio is 32.57 ($174.55 / $5.36).

However, that number by itself tells us little about Microsoft\u2019s valuation or prospects.

What the P/E Ratio Tells You

The P/E is meant to be a quick way to assess a company based on its earnings.

A high P/E ratio relative to its peers, or historically, means investors are expecting higher future earnings growth, and thus are willing to pay more right now. A lower P/E suggests investors believe earnings growth may slow going forward.

For example, Amazon stock has a P/E of over 100 as of April 2020. Compared to other online ecommerce companies, this is high, meaning investors believe the company\u2019s earnings growth will outpace peers in the near-term.

The P/E ratio, in simplistic terms, is how much one dollar of profits cost to invest in the company. In the Amazon example, an investor is effectively paying $100 for every $1 of profits.

Again, the P/E ratio, sometimes referred to as the earnings multiple, is not a good measure of value on a standalone basis. Instead, it\u2019s best used when compared to the industry average or its historical average P/E ratio.

Understanding “what is a good PE ratio for a stock” starts with comparing the P/E ratio to a benchmark. The P/E ratio is meant to display how \u201cexpensive\u201d a stock is relative to its peers (industry) or itself (historically).

Read more: What Is a Good ROE (Return on Equity) and Why Is It Warren Buffett\u2019s Most Important Number?

P/E Ratio and Investor Expectations

P/E ratios are mostly about investor expectations. A stock with a low P/E ratio suggests a company\u2019s profits are expected to decline in the future. A high P/E suggests profits will rise.

Earnings can rise or fall for a variety of reasons, maybe the company is facing increased competition or maybe a new technology is making its products obsolete.

Earnings are how a company is doing. The P/E ratio is how the company is expected to do.

Absolute vs. Relative P/E

A relative P/E ratio is a P/E that is benchmarked.

That is, the P/E ratio is compared to the industry average or historical pe ratios for individual stocks.

Relative P/E is the company\u2019s P/E ratio divided by the chosen average. It\u2019s displayed as a percentage.

For example, the median P/E ratio for Amazon over the last 13 years is 145. Its current P/E ratio is 103, which means its relative P/E based on its historical average is 71%.

How to Analyze Historical PE Ratios

Historical PE ratios are often used with the S&P 500 when doing a technical analysis on trends and deciding whether the overall market is \u201cexpensive\u201d or \u201ccheap.\u201d

For example, the current P/E ratio of the S&P 500 is around 20. The historical average for the S&P 500, dating back to when the index was created in the 1800s, is around 16.

Here\u2019s a historical chart of the S&P 500.

Source: Multpl

The P/E ratio had a low of nearly 5 in 1917 and hit a peak of 124 in 2009.

Based on the historical average, the S&P 500 is slightly overvalued today. That is, the economic and earnings outlook for the S&P 500 is expected to be below historical norms.

When the economy is booming, P/E ratios will be higher than average, and vice versa when the economy is on rocky ground.

This same concept can be applied to industries and individuals stocks. The historical average, which can span several years or decades, is calculated and then compared to the current company or industry pe ratios.

Trailing P/E vs. Forward P/E

The forward P/E ratio is different from the typical (or trailing) P/E ratio.

The typical P/E ratio uses the most recent earnings for the trailing twelve months, hence it\u2019s called the trailing P/E ratio. The forward P/E ratio uses future earnings expectations for the next year.

The downside to using future expected earnings is that earnings expectations might be downplayed by the company. The company may make estimates that are on the low-end to be able to beat earnings expectations.

For a trailing P/E ratio, the issue is that past performance doesn\u2019t mean the same performance will be enjoyed in the future.

Still, if the forward P/E is lower than the trailing P/E then the market expects earnings to increase in the future. If the forward P/E is higher, earnings are expected to fall.

Using the P/E Ratio to Value a Stock

P/E ratios can be used for valuations and identifying the best stocks to buy. In fact, it\u2019s one of the most widely used ratios when analyzing a stock\u2019s value.

P/E vs. PEG Ratio

As mentioned, the P/E ratio alone cannot be used to assess companies.

One variation of the P/E ratio is the price-to-earnings to growth ratio, also known as the PEG ratio. The PEG ratio is calculated as the trailing P/E ratio divided by the future expected growth rate.

The PEG ratio takes into account the current earnings and the expected growth.

A PEG ratio of 1 or less is generally considered an undervalued investment because its price is low compared to growth expectations.

PEG ratios can be forward or trailing as well. Forward PEG ratios use the expected earnings growth rate for a period of time\u2014usually five years. Trailing PEG ratios use the previous five years.

For example, Apple stock has a P/E ratio of 23.3. Its earnings growth rate for the next five years is 12.6% annualized. Thus, its forward PEG ratio is 1.85, or 23.3 / 12.6. Tech stocks have good P/E ratios because of their product releases. Another good example is Sony which gets a lot of its revenue from consoles, especially its PS5 which remains out of stock.

P/E vs. Earnings Yield

Another way of thinking about the P/E ratio is the earnings yield. The earnings yield is inverse of the P/E ratio\u2014which is calculated as earnings per share divided by price per share.

The earnings yield is displayed as a percentage and allows investors to compare a stock to other assets, such as fixed income securities.

Consider this, the earnings yield for McDonald\u2019s is 4.2%, or its EPS of $7.88 divided by its stock price of $187. Meanwhile, its P/E ratio would be 23.7, or $187 / $7.88.

This can then be compared to the return of an asset like the 30-year Treasury bond, which offers a yield of 1.28%.

Shortfalls of P/E Ratios

The P/E ratio for all its usefulness also has its shortcomings.

Firstly, companies that make no earnings have a \u201c0\u201d or \u201cN/A\u201d P/E ratio. If earnings are negative, the P/E ratio can be calculated, but a negative P/E ratio is generally not useful for comparison purposes.

The P/E also can\u2019t be used to compare companies of different industries. As a standalone metric, the P/E ratio may fail to reveal other issues, such as high debt levels.

As well, earnings can be manipulated to downplay expectations or to make the numbers look better. This can skew the P/E ratio.

Finally, the downside to the P/E is that just because the P/E ratio suggests a stock is \u201ccheap\u201d doesn\u2019t mean the investor should buy it. The company could be cheap for a reason, such as the number of customers are in decline.

So ultimately, the answer to the question “what is a good PE ratio for a stock?” is that – like all financial ratios, the P/E ratio is just one indicator that needs to be used in context with other data points and fundamental research in order to make an intelligent investment decision. This is the same if we ask “what is a good ROE“, or “what is a good P/B”, or what is the best entry point of the trade.

Using a stock screener can be a good way to narrow down the universe of stocks by a variety of ratios and metrics, including P/E ratio.

Want to learn more about fundamental analysis? Read this article on How to Know What Stocks to Buy?

Interested in IPOs? Learn how to buy SpaceX stock or how to buy TikTok stock.

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", + "page_last_modified": " Sat, 17 Feb 2024 15:10:48 GMT" + }, + { + "page_name": "What is a Good PE Ratio for a Stock? Is a High P/E Ratio Good or Bad?", + "page_url": "https://www.investmentzen.com/blog/what-is-a-good-pe-ratio-for-a-stock", + "page_snippet": "", + "page_result": " What is a Good PE Ratio for a Stock? Is a High P/E Ratio Good? Historical PE Ratios \n
\"InvestmentZen\"
Home \u00bb Investing \u00bb Stocks

What is a Good PE Ratio for a Stock? Is a High P/E Ratio Good or Bad?

What is a good PE ratio for a stock? Is a high PE ratio good or bad? We’ll dive into the nuances of this all-important stock investing ratio and how to put it in its industry and historical context

By Marshall Hargrave

Equity Analyst

9 Best Stock Screeners (Free & Paid) In 2024
\"stock
Stock Valuation Methods: How To Evaluate A Stock And Calculate Its Intrinsic Value

The price-to-earnings ratio (P/E ratio) is a valuation metric used by investors to get an idea of whether a stock is over- or undervalued. But understanding\u00a0what is a “good” P/E ratio for a stock requires additional context.

Let me explain.

P/E ratio alone isn’t useful. It’s best used as a relative metric i.e. when comparing P/E ratios between similar companies operating within the same industry. This is one of the most common types of fundamental analysis.

Is a High PE Ratio Good or Bad?

If you were wondering “Is a high PE ratio good?”, the short answer is “no”.

The higher the P/E ratio, the more you are paying for each dollar of earnings. This makes a high PE ratio bad for investors, strictly from a price to earnings perspective.

A higher P/E ratio means you are paying more to purchase a share of the company’s earnings.

So, what is a good PE ratio for a stock? A \u201cgood\u201d P/E ratio isn\u2019t necessarily a high ratio or a low ratio on its own.

The market average P/E ratio currently ranges from 20-25, so a higher PE above that could be considered bad, while a lower PE ratio could be considered better.

\"is

However, the long answer is more nuanced than that.

A high P/E ratio, whether compared to the industry average or its historical average, means you are paying more for each dollar of earnings, but it also implies that investors are expecting the company to grow earnings faster in the future, whether it be versus its competitors or its own past growth. Having someone to help you with these will be easier for you to comprehend. However, choosing a professional consultant to guide you with these will be difficult if you don’t understand the difference between an accountant and a bookkeeper.

P/E Ratios Are Only Useful Compared to a Benchmark

A P/E ratio of 10 might be pretty normal for a utility company, while it might be exceptionally low for a software business.

That\u2019s where the industry PE ratios come into play. What\u2019s the expectations of the company relative to its major peers and competitors?

That\u2019s a question that can be answered by comparing a company\u2019s P/E ratio to its industry or historical pe ratios.

A stock market index, such as the S&P 500, can be used to gauge whether the company is over- or undervalued relative to the market.

A P/E ratio can also be benchmarked relative to the industry average P/E, such as comparing McDonald\u2019s to the average P/E ratios of other fast food restaurants.

You can get industry P/E ratio data at WallStreetZen.com. Unlike most stock research websites that just show you P/E ratio as a single number, WallStreetZen shows you the average market P/E ratio, as well as the P/E ratio of the company you’re researching.

In this example from McDonalds (NYSE: MCD), we can see how comparing PE ratio with benchmarks helps us determine whether a PE ratio is relatively good or bad.

This chart from WallStreetZen shows us Mcdonald’s P/E ratio over time, compared to two important benchmarks – the US market P/E ratio average, and the US restaurant industry P/E ratio average.

What’s unique here is that WallStreetZen also runs automated due checks that compare McDonald’s P/E ratio with the US market average and the US Restaurant industry average, and gives you the results in simple, one-line explanations.

In the example above, we can see that Mcdonald’s is poor value relative to the U.S. market from a P/E perspective, but good value relative to the US Restaurant industry.

You can try heading over to WallStreetZen and searching for stock you’re interested in to see how its P/E ratio compares with the industry / market.

How Industry P/E Ratios Work

Industry PE ratios are the average (mean) P/E ratio of all the companies that operate within a certain industry.

For example, the industry P/E for US auto manufacturers would include the average P/E ratio of Ford (NYSE:F), General Motors (NYSE:GM) and Toyota (NYSE:TM), among many others.

If we were to look up the P/E ratio of Tesla (NASDAQ: TSLA), we would want to see how it compares to its peers.

In the example above, we can see that investors are willing to pay more per earnings per share for TSLA, compared to other US automobile manufacturers. If you view Tesla as a promising company disrupting the automobile industry that will continue to take market share from its competitors (like the folks at manufacturing.net), then paying a higher price may make sense.

However, if you’re a skeptic, you would view Tesla as grossly overvalued based on its high price to earnings ratio. It’s often the case that companies have more a reasonable P/E ratio when they first become public \u2014 if you love Tesla and Elon Musk, you may want to keep an eye on the return of Twitter stock to the public market.

Price To Earnings Tells You How Expensive a Stock Is, Relative To Other Stocks

Stock price alone has nothing to do with how \u201cexpensive\u201d a stock is\u2014shares of Booking Holdings (BKNG)\u2014owner of sites like Priceline and Booking.com\u2014trade for nearly $1,400.

However, it\u2019s not as expensive as other top travel website stocks. Booking Holdings has a P/E ratio of 12. Keep that in mind.

Meanwhile, shares of Expedia (EXPE) trade for less than $70 a piece. But its P/E ratio is 18. Then there\u2019s TripAdvisor (TRIP), which trades at $18 a share, yet has a P/E of over 20.

So, while you have to pay $1,400 to buy one share of Booking Holdings stock, you\u2019re effectively only paying $12 for $1 stake in the company’s earnings, given its P/E is 12. For TripAdvisor, you\u2019re paying $20 for a $1 earnings stake.

Now, the reason you\u2019re paying more for TripAdvisor is because investors believe it will grow earnings faster in the future.

The industry P/E ratio for Booking Holdings would include all its major peers and competitors. The travel and leisure industry P/E is roughly 19.

Based on Booking Holdings 12 P/E, the company is expected to grow its earnings at a rate below the travel and leisure industry. Whether that will happen or not is something you have to decide for yourself.

If you believe the market is missing something and that Booking Holdings is well positioned to take market share from a competitor then the stock could be considered \u201cundervalued.\u201d

Industry P/E Ratios for Individual Stocks

Different industries have different P/E ratios that are considered \u201cnormal.\u201d

For example, some industries trade at an average of 15 times earnings, while others trade at 30 times. It\u2019s because some industries have different expectations.

Utility companies tend to have lower P/E ratios given their low historical earnings. Meanwhile, technology companies have enjoyed higher P/E ratios due to their higher earnings growth.

Consider this, during the Great Recession technology stocks had lower P/E ratios than consumer staple stocks. That\u2019s because investors expected consumer staples, like toothpaste and groceries, were expected to outperform tech stocks in the near-term.

How to Calculate the P/E Ratio

The easy way to think about P/E ratio is\u2014it\u2019s what you\u2019d pay for $1 of a company\u2019s earnings. The formula for P/E ratio is:

Price-to-Earnings (P/E) Ratio = Stock Price / Earnings Per Share (EPS)

Most financial websites openly publish the P/E ratio, so you don’t have to calculate it from scratch. However, understanding where they are getting the numbers is always useful.

A P/E ratio includes a company\u2019s stock price, which can be found in any number of stock research websites. But when it comes to the earnings per share (EPS) part, some sites and sources use the trailing twelve months\u2019 (TTM) earnings, while others stick to the fiscal year\u2014which many times ends on Dec. 31, but can end on other dates.

So if a stock is trading for $20 a share and made $2 in EPS over the trailing twelve months, its P/E ratio is 10, ($20 / $2).

A company\u2019s earnings is its net income. Earnings per share (EPS) is the company\u2019s net income divided by its total shares outstanding. (Note for dividend investors: Earnings are calculated before dividend payments are distributed)

For example, to calculate Microsoft\u2019s P/E ratio, you\u2019d first need to calculate Microsoft\u2019s earnings per shares.

For the trailing twelve months (TTM), which is the four most recent quarters of reported financials, Microsoft has posted EPS of $5.36. Its shares outstanding is 7.673 billion. As of Apr. 25, 2020, Microsoft\u2019s stock price is $174.55.\u00a0\u00a0Thus, its P/E ratio is 32.57 ($174.55 / $5.36).

However, that number by itself tells us little about Microsoft\u2019s valuation or prospects.

What the P/E Ratio Tells You

The P/E is meant to be a quick way to assess a company based on its earnings.

A high P/E ratio relative to its peers, or historically, means investors are expecting higher future earnings growth, and thus are willing to pay more right now. A lower P/E suggests investors believe earnings growth may slow going forward.

For example, Amazon stock has a P/E of over 100 as of April 2020. Compared to other online ecommerce companies, this is high, meaning investors believe the company\u2019s earnings growth will outpace peers in the near-term.

The P/E ratio, in simplistic terms, is how much one dollar of profits cost to invest in the company. In the Amazon example, an investor is effectively paying $100 for every $1 of profits.

Again, the P/E ratio, sometimes referred to as the earnings multiple, is not a good measure of value on a standalone basis. Instead, it\u2019s best used when compared to the industry average or its historical average P/E ratio.

Understanding “what is a good PE ratio for a stock” starts with comparing the P/E ratio to a benchmark. The P/E ratio is meant to display how \u201cexpensive\u201d a stock is relative to its peers (industry) or itself (historically).

Read more: What Is a Good ROE (Return on Equity) and Why Is It Warren Buffett\u2019s Most Important Number?

P/E Ratio and Investor Expectations

P/E ratios are mostly about investor expectations. A stock with a low P/E ratio suggests a company\u2019s profits are expected to decline in the future. A high P/E suggests profits will rise.

Earnings can rise or fall for a variety of reasons, maybe the company is facing increased competition or maybe a new technology is making its products obsolete.

Earnings are how a company is doing. The P/E ratio is how the company is expected to do.

Absolute vs. Relative P/E

A relative P/E ratio is a P/E that is benchmarked.

That is, the P/E ratio is compared to the industry average or historical pe ratios for individual stocks.

Relative P/E is the company\u2019s P/E ratio divided by the chosen average. It\u2019s displayed as a percentage.

For example, the median P/E ratio for Amazon over the last 13 years is 145. Its current P/E ratio is 103, which means its relative P/E based on its historical average is 71%.

How to Analyze Historical PE Ratios

Historical PE ratios are often used with the S&P 500 when doing a technical analysis on trends and deciding whether the overall market is \u201cexpensive\u201d or \u201ccheap.\u201d

For example, the current P/E ratio of the S&P 500 is around 20. The historical average for the S&P 500, dating back to when the index was created in the 1800s, is around 16.

Here\u2019s a historical chart of the S&P 500.

Source: Multpl

The P/E ratio had a low of nearly 5 in 1917 and hit a peak of 124 in 2009.

Based on the historical average, the S&P 500 is slightly overvalued today. That is, the economic and earnings outlook for the S&P 500 is expected to be below historical norms.

When the economy is booming, P/E ratios will be higher than average, and vice versa when the economy is on rocky ground.

This same concept can be applied to industries and individuals stocks. The historical average, which can span several years or decades, is calculated and then compared to the current company or industry pe ratios.

Trailing P/E vs. Forward P/E

The forward P/E ratio is different from the typical (or trailing) P/E ratio.

The typical P/E ratio uses the most recent earnings for the trailing twelve months, hence it\u2019s called the trailing P/E ratio. The forward P/E ratio uses future earnings expectations for the next year.

The downside to using future expected earnings is that earnings expectations might be downplayed by the company. The company may make estimates that are on the low-end to be able to beat earnings expectations.

For a trailing P/E ratio, the issue is that past performance doesn\u2019t mean the same performance will be enjoyed in the future.

Still, if the forward P/E is lower than the trailing P/E then the market expects earnings to increase in the future. If the forward P/E is higher, earnings are expected to fall.

Using the P/E Ratio to Value a Stock

P/E ratios can be used for valuations and identifying the best stocks to buy. In fact, it\u2019s one of the most widely used ratios when analyzing a stock\u2019s value.

P/E vs. PEG Ratio

As mentioned, the P/E ratio alone cannot be used to assess companies.

One variation of the P/E ratio is the price-to-earnings to growth ratio, also known as the PEG ratio. The PEG ratio is calculated as the trailing P/E ratio divided by the future expected growth rate.

The PEG ratio takes into account the current earnings and the expected growth.

A PEG ratio of 1 or less is generally considered an undervalued investment because its price is low compared to growth expectations.

PEG ratios can be forward or trailing as well. Forward PEG ratios use the expected earnings growth rate for a period of time\u2014usually five years. Trailing PEG ratios use the previous five years.

For example, Apple stock has a P/E ratio of 23.3. Its earnings growth rate for the next five years is 12.6% annualized. Thus, its forward PEG ratio is 1.85, or 23.3 / 12.6. Tech stocks have good P/E ratios because of their product releases. Another good example is Sony which gets a lot of its revenue from consoles, especially its PS5 which remains out of stock.

P/E vs. Earnings Yield

Another way of thinking about the P/E ratio is the earnings yield. The earnings yield is inverse of the P/E ratio\u2014which is calculated as earnings per share divided by price per share.

The earnings yield is displayed as a percentage and allows investors to compare a stock to other assets, such as fixed income securities.

Consider this, the earnings yield for McDonald\u2019s is 4.2%, or its EPS of $7.88 divided by its stock price of $187. Meanwhile, its P/E ratio would be 23.7, or $187 / $7.88.

This can then be compared to the return of an asset like the 30-year Treasury bond, which offers a yield of 1.28%.

Shortfalls of P/E Ratios

The P/E ratio for all its usefulness also has its shortcomings.

Firstly, companies that make no earnings have a \u201c0\u201d or \u201cN/A\u201d P/E ratio. If earnings are negative, the P/E ratio can be calculated, but a negative P/E ratio is generally not useful for comparison purposes.

The P/E also can\u2019t be used to compare companies of different industries. As a standalone metric, the P/E ratio may fail to reveal other issues, such as high debt levels.

As well, earnings can be manipulated to downplay expectations or to make the numbers look better. This can skew the P/E ratio.

Finally, the downside to the P/E is that just because the P/E ratio suggests a stock is \u201ccheap\u201d doesn\u2019t mean the investor should buy it. The company could be cheap for a reason, such as the number of customers are in decline.

So ultimately, the answer to the question “what is a good PE ratio for a stock?” is that – like all financial ratios, the P/E ratio is just one indicator that needs to be used in context with other data points and fundamental research in order to make an intelligent investment decision. This is the same if we ask “what is a good ROE“, or “what is a good P/B”, or what is the best entry point of the trade.

Using a stock screener can be a good way to narrow down the universe of stocks by a variety of ratios and metrics, including P/E ratio.

Want to learn more about fundamental analysis? Read this article on How to Know What Stocks to Buy?

Interested in IPOs? Learn how to buy SpaceX stock or how to buy TikTok stock.

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", + "page_last_modified": " Sat, 17 Feb 2024 15:10:48 GMT" + }, + { + "page_name": "What is a Good PE Ratio for a Stock? Is a High P/E Ratio Good or Bad?", + "page_url": "https://www.investmentzen.com/blog/what-is-a-good-pe-ratio-for-a-stock", + "page_snippet": "", + "page_result": " What is a Good PE Ratio for a Stock? Is a High P/E Ratio Good? Historical PE Ratios \n
\"InvestmentZen\"
Home \u00bb Investing \u00bb Stocks

What is a Good PE Ratio for a Stock? Is a High P/E Ratio Good or Bad?

What is a good PE ratio for a stock? Is a high PE ratio good or bad? We’ll dive into the nuances of this all-important stock investing ratio and how to put it in its industry and historical context

By Marshall Hargrave

Equity Analyst

9 Best Stock Screeners (Free & Paid) In 2024
\"stock
Stock Valuation Methods: How To Evaluate A Stock And Calculate Its Intrinsic Value

The price-to-earnings ratio (P/E ratio) is a valuation metric used by investors to get an idea of whether a stock is over- or undervalued. But understanding\u00a0what is a “good” P/E ratio for a stock requires additional context.

Let me explain.

P/E ratio alone isn’t useful. It’s best used as a relative metric i.e. when comparing P/E ratios between similar companies operating within the same industry. This is one of the most common types of fundamental analysis.

Is a High PE Ratio Good or Bad?

If you were wondering “Is a high PE ratio good?”, the short answer is “no”.

The higher the P/E ratio, the more you are paying for each dollar of earnings. This makes a high PE ratio bad for investors, strictly from a price to earnings perspective.

A higher P/E ratio means you are paying more to purchase a share of the company’s earnings.

So, what is a good PE ratio for a stock? A \u201cgood\u201d P/E ratio isn\u2019t necessarily a high ratio or a low ratio on its own.

The market average P/E ratio currently ranges from 20-25, so a higher PE above that could be considered bad, while a lower PE ratio could be considered better.

\"is

However, the long answer is more nuanced than that.

A high P/E ratio, whether compared to the industry average or its historical average, means you are paying more for each dollar of earnings, but it also implies that investors are expecting the company to grow earnings faster in the future, whether it be versus its competitors or its own past growth. Having someone to help you with these will be easier for you to comprehend. However, choosing a professional consultant to guide you with these will be difficult if you don’t understand the difference between an accountant and a bookkeeper.

P/E Ratios Are Only Useful Compared to a Benchmark

A P/E ratio of 10 might be pretty normal for a utility company, while it might be exceptionally low for a software business.

That\u2019s where the industry PE ratios come into play. What\u2019s the expectations of the company relative to its major peers and competitors?

That\u2019s a question that can be answered by comparing a company\u2019s P/E ratio to its industry or historical pe ratios.

A stock market index, such as the S&P 500, can be used to gauge whether the company is over- or undervalued relative to the market.

A P/E ratio can also be benchmarked relative to the industry average P/E, such as comparing McDonald\u2019s to the average P/E ratios of other fast food restaurants.

You can get industry P/E ratio data at WallStreetZen.com. Unlike most stock research websites that just show you P/E ratio as a single number, WallStreetZen shows you the average market P/E ratio, as well as the P/E ratio of the company you’re researching.

In this example from McDonalds (NYSE: MCD), we can see how comparing PE ratio with benchmarks helps us determine whether a PE ratio is relatively good or bad.

This chart from WallStreetZen shows us Mcdonald’s P/E ratio over time, compared to two important benchmarks – the US market P/E ratio average, and the US restaurant industry P/E ratio average.

What’s unique here is that WallStreetZen also runs automated due checks that compare McDonald’s P/E ratio with the US market average and the US Restaurant industry average, and gives you the results in simple, one-line explanations.

In the example above, we can see that Mcdonald’s is poor value relative to the U.S. market from a P/E perspective, but good value relative to the US Restaurant industry.

You can try heading over to WallStreetZen and searching for stock you’re interested in to see how its P/E ratio compares with the industry / market.

How Industry P/E Ratios Work

Industry PE ratios are the average (mean) P/E ratio of all the companies that operate within a certain industry.

For example, the industry P/E for US auto manufacturers would include the average P/E ratio of Ford (NYSE:F), General Motors (NYSE:GM) and Toyota (NYSE:TM), among many others.

If we were to look up the P/E ratio of Tesla (NASDAQ: TSLA), we would want to see how it compares to its peers.

In the example above, we can see that investors are willing to pay more per earnings per share for TSLA, compared to other US automobile manufacturers. If you view Tesla as a promising company disrupting the automobile industry that will continue to take market share from its competitors (like the folks at manufacturing.net), then paying a higher price may make sense.

However, if you’re a skeptic, you would view Tesla as grossly overvalued based on its high price to earnings ratio. It’s often the case that companies have more a reasonable P/E ratio when they first become public \u2014 if you love Tesla and Elon Musk, you may want to keep an eye on the return of Twitter stock to the public market.

Price To Earnings Tells You How Expensive a Stock Is, Relative To Other Stocks

Stock price alone has nothing to do with how \u201cexpensive\u201d a stock is\u2014shares of Booking Holdings (BKNG)\u2014owner of sites like Priceline and Booking.com\u2014trade for nearly $1,400.

However, it\u2019s not as expensive as other top travel website stocks. Booking Holdings has a P/E ratio of 12. Keep that in mind.

Meanwhile, shares of Expedia (EXPE) trade for less than $70 a piece. But its P/E ratio is 18. Then there\u2019s TripAdvisor (TRIP), which trades at $18 a share, yet has a P/E of over 20.

So, while you have to pay $1,400 to buy one share of Booking Holdings stock, you\u2019re effectively only paying $12 for $1 stake in the company’s earnings, given its P/E is 12. For TripAdvisor, you\u2019re paying $20 for a $1 earnings stake.

Now, the reason you\u2019re paying more for TripAdvisor is because investors believe it will grow earnings faster in the future.

The industry P/E ratio for Booking Holdings would include all its major peers and competitors. The travel and leisure industry P/E is roughly 19.

Based on Booking Holdings 12 P/E, the company is expected to grow its earnings at a rate below the travel and leisure industry. Whether that will happen or not is something you have to decide for yourself.

If you believe the market is missing something and that Booking Holdings is well positioned to take market share from a competitor then the stock could be considered \u201cundervalued.\u201d

Industry P/E Ratios for Individual Stocks

Different industries have different P/E ratios that are considered \u201cnormal.\u201d

For example, some industries trade at an average of 15 times earnings, while others trade at 30 times. It\u2019s because some industries have different expectations.

Utility companies tend to have lower P/E ratios given their low historical earnings. Meanwhile, technology companies have enjoyed higher P/E ratios due to their higher earnings growth.

Consider this, during the Great Recession technology stocks had lower P/E ratios than consumer staple stocks. That\u2019s because investors expected consumer staples, like toothpaste and groceries, were expected to outperform tech stocks in the near-term.

How to Calculate the P/E Ratio

The easy way to think about P/E ratio is\u2014it\u2019s what you\u2019d pay for $1 of a company\u2019s earnings. The formula for P/E ratio is:

Price-to-Earnings (P/E) Ratio = Stock Price / Earnings Per Share (EPS)

Most financial websites openly publish the P/E ratio, so you don’t have to calculate it from scratch. However, understanding where they are getting the numbers is always useful.

A P/E ratio includes a company\u2019s stock price, which can be found in any number of stock research websites. But when it comes to the earnings per share (EPS) part, some sites and sources use the trailing twelve months\u2019 (TTM) earnings, while others stick to the fiscal year\u2014which many times ends on Dec. 31, but can end on other dates.

So if a stock is trading for $20 a share and made $2 in EPS over the trailing twelve months, its P/E ratio is 10, ($20 / $2).

A company\u2019s earnings is its net income. Earnings per share (EPS) is the company\u2019s net income divided by its total shares outstanding. (Note for dividend investors: Earnings are calculated before dividend payments are distributed)

For example, to calculate Microsoft\u2019s P/E ratio, you\u2019d first need to calculate Microsoft\u2019s earnings per shares.

For the trailing twelve months (TTM), which is the four most recent quarters of reported financials, Microsoft has posted EPS of $5.36. Its shares outstanding is 7.673 billion. As of Apr. 25, 2020, Microsoft\u2019s stock price is $174.55.\u00a0\u00a0Thus, its P/E ratio is 32.57 ($174.55 / $5.36).

However, that number by itself tells us little about Microsoft\u2019s valuation or prospects.

What the P/E Ratio Tells You

The P/E is meant to be a quick way to assess a company based on its earnings.

A high P/E ratio relative to its peers, or historically, means investors are expecting higher future earnings growth, and thus are willing to pay more right now. A lower P/E suggests investors believe earnings growth may slow going forward.

For example, Amazon stock has a P/E of over 100 as of April 2020. Compared to other online ecommerce companies, this is high, meaning investors believe the company\u2019s earnings growth will outpace peers in the near-term.

The P/E ratio, in simplistic terms, is how much one dollar of profits cost to invest in the company. In the Amazon example, an investor is effectively paying $100 for every $1 of profits.

Again, the P/E ratio, sometimes referred to as the earnings multiple, is not a good measure of value on a standalone basis. Instead, it\u2019s best used when compared to the industry average or its historical average P/E ratio.

Understanding “what is a good PE ratio for a stock” starts with comparing the P/E ratio to a benchmark. The P/E ratio is meant to display how \u201cexpensive\u201d a stock is relative to its peers (industry) or itself (historically).

Read more: What Is a Good ROE (Return on Equity) and Why Is It Warren Buffett\u2019s Most Important Number?

P/E Ratio and Investor Expectations

P/E ratios are mostly about investor expectations. A stock with a low P/E ratio suggests a company\u2019s profits are expected to decline in the future. A high P/E suggests profits will rise.

Earnings can rise or fall for a variety of reasons, maybe the company is facing increased competition or maybe a new technology is making its products obsolete.

Earnings are how a company is doing. The P/E ratio is how the company is expected to do.

Absolute vs. Relative P/E

A relative P/E ratio is a P/E that is benchmarked.

That is, the P/E ratio is compared to the industry average or historical pe ratios for individual stocks.

Relative P/E is the company\u2019s P/E ratio divided by the chosen average. It\u2019s displayed as a percentage.

For example, the median P/E ratio for Amazon over the last 13 years is 145. Its current P/E ratio is 103, which means its relative P/E based on its historical average is 71%.

How to Analyze Historical PE Ratios

Historical PE ratios are often used with the S&P 500 when doing a technical analysis on trends and deciding whether the overall market is \u201cexpensive\u201d or \u201ccheap.\u201d

For example, the current P/E ratio of the S&P 500 is around 20. The historical average for the S&P 500, dating back to when the index was created in the 1800s, is around 16.

Here\u2019s a historical chart of the S&P 500.

Source: Multpl

The P/E ratio had a low of nearly 5 in 1917 and hit a peak of 124 in 2009.

Based on the historical average, the S&P 500 is slightly overvalued today. That is, the economic and earnings outlook for the S&P 500 is expected to be below historical norms.

When the economy is booming, P/E ratios will be higher than average, and vice versa when the economy is on rocky ground.

This same concept can be applied to industries and individuals stocks. The historical average, which can span several years or decades, is calculated and then compared to the current company or industry pe ratios.

Trailing P/E vs. Forward P/E

The forward P/E ratio is different from the typical (or trailing) P/E ratio.

The typical P/E ratio uses the most recent earnings for the trailing twelve months, hence it\u2019s called the trailing P/E ratio. The forward P/E ratio uses future earnings expectations for the next year.

The downside to using future expected earnings is that earnings expectations might be downplayed by the company. The company may make estimates that are on the low-end to be able to beat earnings expectations.

For a trailing P/E ratio, the issue is that past performance doesn\u2019t mean the same performance will be enjoyed in the future.

Still, if the forward P/E is lower than the trailing P/E then the market expects earnings to increase in the future. If the forward P/E is higher, earnings are expected to fall.

Using the P/E Ratio to Value a Stock

P/E ratios can be used for valuations and identifying the best stocks to buy. In fact, it\u2019s one of the most widely used ratios when analyzing a stock\u2019s value.

P/E vs. PEG Ratio

As mentioned, the P/E ratio alone cannot be used to assess companies.

One variation of the P/E ratio is the price-to-earnings to growth ratio, also known as the PEG ratio. The PEG ratio is calculated as the trailing P/E ratio divided by the future expected growth rate.

The PEG ratio takes into account the current earnings and the expected growth.

A PEG ratio of 1 or less is generally considered an undervalued investment because its price is low compared to growth expectations.

PEG ratios can be forward or trailing as well. Forward PEG ratios use the expected earnings growth rate for a period of time\u2014usually five years. Trailing PEG ratios use the previous five years.

For example, Apple stock has a P/E ratio of 23.3. Its earnings growth rate for the next five years is 12.6% annualized. Thus, its forward PEG ratio is 1.85, or 23.3 / 12.6. Tech stocks have good P/E ratios because of their product releases. Another good example is Sony which gets a lot of its revenue from consoles, especially its PS5 which remains out of stock.

P/E vs. Earnings Yield

Another way of thinking about the P/E ratio is the earnings yield. The earnings yield is inverse of the P/E ratio\u2014which is calculated as earnings per share divided by price per share.

The earnings yield is displayed as a percentage and allows investors to compare a stock to other assets, such as fixed income securities.

Consider this, the earnings yield for McDonald\u2019s is 4.2%, or its EPS of $7.88 divided by its stock price of $187. Meanwhile, its P/E ratio would be 23.7, or $187 / $7.88.

This can then be compared to the return of an asset like the 30-year Treasury bond, which offers a yield of 1.28%.

Shortfalls of P/E Ratios

The P/E ratio for all its usefulness also has its shortcomings.

Firstly, companies that make no earnings have a \u201c0\u201d or \u201cN/A\u201d P/E ratio. If earnings are negative, the P/E ratio can be calculated, but a negative P/E ratio is generally not useful for comparison purposes.

The P/E also can\u2019t be used to compare companies of different industries. As a standalone metric, the P/E ratio may fail to reveal other issues, such as high debt levels.

As well, earnings can be manipulated to downplay expectations or to make the numbers look better. This can skew the P/E ratio.

Finally, the downside to the P/E is that just because the P/E ratio suggests a stock is \u201ccheap\u201d doesn\u2019t mean the investor should buy it. The company could be cheap for a reason, such as the number of customers are in decline.

So ultimately, the answer to the question “what is a good PE ratio for a stock?” is that – like all financial ratios, the P/E ratio is just one indicator that needs to be used in context with other data points and fundamental research in order to make an intelligent investment decision. This is the same if we ask “what is a good ROE“, or “what is a good P/B”, or what is the best entry point of the trade.

Using a stock screener can be a good way to narrow down the universe of stocks by a variety of ratios and metrics, including P/E ratio.

Want to learn more about fundamental analysis? Read this article on How to Know What Stocks to Buy?

Interested in IPOs? Learn how to buy SpaceX stock or how to buy TikTok stock.

Share42
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", + "page_last_modified": " Sat, 17 Feb 2024 15:10:48 GMT" + }, + { + "page_name": "What Is a Good P/E Ratio? Is High or Low Better? | SmartAsset", + "page_url": "https://smartasset.com/investing/what-is-a-good-pe-ratio", + "page_snippet": "", + "page_result": "What Is a Good P/E Ratio? Is High or Low Better? | SmartAsset
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What Is a Good P/E Ratio? Is High or Low Better?

Updated on
Written\u00a0by\u00a0Amelia Josephson
Edited\u00a0by\u00a0Jeff White
Share
\"SmartAsset:

P/E ratio, or price-to-earnings ratio, is a quick way to see if a stock is undervalued or overvalued. And so generally speaking, the lower the P/E ratio is, the better it is for both the business and potential investors. The metric is the stock price of a company divided by its earnings per share. You shouldn\u2019t compare P/E ratios of different kinds of companies, like a tech company and a consumer staple company. In other words, the metric is only useful when comparing apples to apples. If you want help with using P/E ratios to invest your money, consider working with a financial advisor.

P/E Ratio: Why It\u2019s Important

You don\u2019t have to calculate each company\u2019s P/E ratio yourself. After all, you can just Google it. But in case you\u2019re curious, the ratio is the share price divided by earnings per share. The resulting number tells you how much you are paying per dollar that the company earns. Here\u2019s the formula:

Share Price \u00f7 Earnings Per Share = P/E Ratio

For example, a ratio of 15 would mean that investors are willing to pay $15 for every dollar of company earnings. This is why the P/E ratio is sometimes referred to as the \u201cearnings multiple\u201d or just \u201cmultiple.\u201d

You generally use the P/E ratio by comparing it to other P/E ratios of companies in the same industry or to past P/E ratios of the same company. If you are comparing same-sector companies, the one with the lower P/E may be undervalued. Or if you\u2019re looking at past data for one company, a higher number could mean it\u2019s no longer a bargain.

How to Tell If a P/E Ratio Is Good or Bad

Ultimately, there\u2019s no hard-and-fast rule for what a good P/E ratio is. But in general, many value investors consider a lower P/E ratio better. Again, these ratios are often used in a comparative sense, so what\u2019s good or bad is often dependent on what you\u2019re comparing it against.

To give you some sense of what the average for the market is, though, many value investors would refer to 20 to 25 as the average P/E ratio range. And again, like golf, the lower the P/E ratio a company has, the better an investment the metric is saying it is.

However, the above assumes a value mindset when looking at the market. If you prefer to invest in larger, less volatile company stocks, you may be willing to pay up for a pricier investment with a higher P/E ratio.

The Drawbacks of Using P/E Ratio to Evaluate Investments

\"SmartAsset:

The P/E ratio seems like a straightforward calculation, but what you use for earnings can be tricky. For one thing, earnings are reported by each company, and accounting practices are not the same across the board. There\u2019s also the possibility that a company is inflating earnings by devaluing or hiding costs.

That\u2019s partly why it\u2019s a good idea to take the P/E ratio with a grain of salt. Another reason: a company with a high ratio could have high growth prospects. Its ratio is high because it is spending a lot of money to grow its business. So it could still be a good buy.

In other words, you shouldn\u2019t just zero in on the P/E ratio when you\u2019re deciding whether to buy shares. There are many other metrics to consider, including earnings charts, sales figures and other fundamentals of a company. You can also look at the dividend rate if you\u2019re going for dividend investing. Exhaustive research should lead you to more prudent investments. If you don\u2019t have the time, consider hiring a financial advisor.

Best P/E Ratio Stock Examples

The lower the p/e ratio, the better a stock is perceived to be for an investor because the low p/e ratio is great for the business itself. Here are six stocks with low and high p/e ratios from April 2023:

    \n
  • AcelRx Pharmaceuticals, Inc. (ACRX): -0.25
    • \n\n\n\n
  • ZIM Integrated Shipping Services Ltd. (ZIM): 0.67
    • \n\n\n\n
  • Jackson Financial Inc. (JXN): 7.93
    • \n\n\n\n
  • Globus Maritime Limited (GLBS): 27.11
    • \n\n\n\n
  • Zoetis Inc. (ZTS): 37.00
    • \n\n\n\n
  • The Walt Disney Company (DIS): 73.40
    • \n

Bottom Line

It\u2019s a good idea for investors to understand the P/E ratio and how to use it to evaluate share prices. But it\u2019s only one of many available metrics. It shouldn\u2019t be used alone, and it shouldn\u2019t be used to compare companies that are in different businesses. That said, it is a handy way of seeing if a stock is a bargain or not. You can use it to find the right investments for your portfolio.

Tips to Become a Better Investor

\"SmartAsset:
    \n
  • Financial advisors often have years of experience managing investments, making them great partners for anyone looking to improve their portfolio. Finding a financial advisor doesn\u2019t have to be hard. SmartAsset\u2019s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you\u2019re ready to find an advisor who can help you achieve your financial goals, get started now.
    • \n\n\n\n
  • Exchange-traded funds, or ETFs, can be a great way to quickly flesh out your existing portfolio. Like mutual funds, ETFs are baskets of stocks that carry less overall risk than an individual company\u2019s stock does. But unlike mutual funds, you can trade ETFs very easily, buying or selling them very quickly.
    • \n\n\n\n
  • If you\u2019re unsure about how much money an investment could make, SmartAsset\u2019s free investment calculator could help you get an estimate.
    • \n

Photo credit: \u00a9iStock.com/DragonImages, \u00a9iStock.com/naito8, \u00a9iStock.com/blackred

...
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SmartAsset Advisors, LLC ("SmartAsset"), a wholly owned subsidiary of Financial Insight Technology, is registered with the U.S. Securities and Exchange Commission as an investment adviser. SmartAsset's services are limited to referring users to third party advisers registered or chartered as fiduciaries ("Adviser(s)") with a regulatory body in the United States that have elected to participate in our matching platform based on information gathered from users through our online questionnaire. SmartAsset receives compensation from Advisers for our services. SmartAsset does not review the ongoing performance of any Adviser, participate in the management of any user's account by an Adviser or provide advice regarding specific investments.

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\n \n 5 min read\n \n Published August 31, 2023\n
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\n Written by\n \n \n Brian Baker, CFA\n Arrow Right \n \n Writer, investing and retirement\n
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\n Brian Baker covers investing and retirement for Bankrate. He is a CFA Charterholder and previously worked in equity research at a buyside investment firm. Baker is passionate about helping people make sense of complicated financial topics so that they can better plan for their financial futures.\n
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\n Edited by\n \n \n Brian Beers\n Arrow Right \n \n Managing editor\n
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\n Brian Beers is the managing editor for the Wealth team at Bankrate. He oversees editorial coverage of banking, investing, the economy and all things money.\n
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For investors who are looking to invest beyond diversified mutual funds or ETFs, individual stocks can be a profitable option. But before you start buying individual stocks, you\u2019ll need to know how to analyze their underlying businesses.

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A good place to start is a company\u2019s filings with the Securities and Exchange Commission. These filings will provide a great amount of information, including financial statements for the most recent year. From there you can calculate financial ratios to aid your understanding of the business and where the stock\u2019s price might be headed.

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Here are the most important ratios for investors to know when looking at a stock.

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1. Earnings per share (EPS)

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Earnings per share, or EPS, is one of the most common ratios used in the financial world. This number tells you how much a company earns in profit for each outstanding share of stock. EPS is calculated by dividing a company\u2019s net income by the total number of shares outstanding.

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Knowing this ratio is important for stock investors, but understanding its limits is also crucial. Executives have a lot of control over various accounting practices that can impact net income and earnings per share. Make sure you understand how earnings are calculated and don\u2019t just take EPS at face value.

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2. Price/earnings ratio (P/E)\n

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Another common financial ratio is the P/E ratio, which takes a company\u2019s stock price and divides it by earnings per share. This is a valuation ratio, meaning it\u2019s used by investors to determine how much value they\u2019re getting relative to what they\u2019re paying for a share of stock.

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Profitable businesses with average or below-average growth prospects tend to trade at lower P/E ratios than businesses expected to grow at high rates. One of the world\u2019s most successful investors, Warren Buffett, has made a fortune buying shares in businesses with solid growth prospects that trade at low P/E ratios. An investment in Coca-Cola (KO) in the 1980s and a more recent investment in Apple (AAPL) when each was selling for a low P/E ratio have made billions for Berkshire Hathaway shareholders.

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P/E ratios can be calculated using trailing earnings, or earnings that have already been earned, as well as forward earnings, which are projections for what the company may earn in the future.

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For fast-growing companies, looking at the forward P/E ratio may be more useful than using historical earnings that can cause the ratio to be elevated. But remember that projections are not guaranteed and many stocks of companies that were once thought of as fast-growers suffered when that growth failed to materialize.

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The P/E ratio can also be inverted to calculate an earnings yield. By taking earnings per share and dividing by the stock price, investors can compare the yield easily to other investment opportunities.

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3. Return on equity (ROE)\n

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One of the most important ratios for investors to understand is return on equity, or the return a company generates on its shareholders\u2019 capital. In one sense, it\u2019s a measure of how good a company is at turning its shareholders\u2019 money into more money. If you have two companies that each earned $1 million this year, but one company invested $10 million to generate those earnings while the other only needed $5 million, it\u2019d be clear that the second company had a better business that year.

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In its simplest form, return on equity is calculated by dividing a company\u2019s net income by its shareholder equity. Generally, the higher a company\u2019s return on equity is, the better its underlying business. But these high returns tend to attract other companies who\u2019d also like to earn high returns, potentially leading to increased competition. More competition is almost always a negative for a business and can drive once-high returns on equity down to more normal levels.

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4. Debt-to-capital ratio

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In addition to tracking a company\u2019s profitability, you\u2019ll also want to understand how the business is financed and whether it can support the levels of debt it has. One way to look at this is the debt-to-capital ratio, which adds short- and long-term debt, and divides it by the company\u2019s total capital.

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The higher the ratio is, the more a company is indebted. In general, debt-to-capital ratios above 40 percent warrant a closer look to make sure the company can handle the debt load.

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The type of financing a company uses will depend on the individual circumstances of that company. Businesses that are more cyclical should rely less on debt financing to avoid potential defaults during economic downturns when revenues and profits tend to be lower. Conversely, businesses that are steady, consistent performers can often support above-average levels of debt due to their more predictable nature.

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5. Interest coverage ratio (ICR)

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The interest coverage ratio is another good way to measure whether a company can support the amount of debt it has. Interest coverage can be calculated by taking earnings before interest and taxes, or EBIT, and dividing by interest expense. This number tells you the extent to which earnings cover interest payments owed to bondholders. The higher the ratio, the more coverage the company has for its debt payments.

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Remember, though, that earnings don\u2019t always stay the same. A cyclical company operating near a peak might show great interest coverage due to its elevated earnings, but that can evaporate when earnings fall. You\u2019ll want to make sure a company can meet its obligations during a variety of economic conditions.

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6. Enterprise value to EBIT

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The enterprise value to EBIT ratio is essentially a more advanced version of the P/E ratio. Both ratios are a way for investors to measure how much value they\u2019re getting compared to what they\u2019re paying. But using enterprise value instead of the share price allows us to incorporate any debt financing used by the company. Here\u2019s how it works.

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Enterprise value can be calculated by adding a company\u2019s interest-bearing debt, net of cash, to its market capitalization, which is the total value of all its outstanding stock. Next, by using EBIT you can more easily compare the actual operating earnings of a business with other companies that may have different tax rates or debt levels.

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7. Operating margin

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Operating margin is a way of measuring the profitability of a business\u2019 core operations. It\u2019s calculated by dividing operating profit by total revenues and shows how much income is generated by each dollar of sales.

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Operating income takes revenue and subtracts the cost of sales and all operating expenses, such as employee and marketing costs. Calculating an operating margin can help you compare with other businesses without having to make adjustments for differences in debt financing or tax rates.

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8. Quick ratio

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Also known as the acid test, the quick ratio measures whether a company can meet its short-term obligations with assets that can quickly be converted into cash. The ratio is useful for analyzing companies facing financial difficulties or during economic downturns when profits may be hard to come by.

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The ratio sums a company\u2019s cash, marketable securities and accounts receivable and divides by its current liabilities. All of these figures can be found on the company\u2019s most recent balance sheet. Importantly, inventory is excluded from the list of assets because it can\u2019t be relied upon for a quick conversion to cash.

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If the ratio is one or less, the company may need to raise additional funds from investors or hope to see an improvement in its business quickly.

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Bottom line

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These financial ratios and others will aid your understanding of a business, but they should always be looked at in totality rather than focusing on just one or two ratios. Financial analysis using ratios is just one step in the process of investing in a company\u2019s stock. Be sure to also research management and read what they\u2019re saying about a business. Sometimes the things that can\u2019t be easily measured by financial ratios matter most for the future of a business.

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\n Brian Baker covers investing and retirement for Bankrate. He is a CFA Charterholder and previously worked in equity research at a buyside investment firm. Baker is passionate about helping people make sense of complicated financial topics so that they can better plan for their financial futures.\n
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\n Edited by\n \n \n Brian Beers\n Arrow Right \n \n Managing editor\n
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\n Brian Beers is the managing editor for the Wealth team at Bankrate. He oversees editorial coverage of banking, investing, the economy and all things money.\n
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