In this stock market and the latest period of new IPOs, there are a lot of people on Wall Street clamoring about where a stock is selling, or its “multiple.” The reference is to the price-to-earnings (P/E) ratio.  While it’s one of the oldest and most frequently used metrics, it can also get you into some trouble if taken out of context.

In this article, we will define the P/E ratio and explain what it is and how you should use it. Although it can reveal important information about a company, it’s also important to understand its limitations when evaluating a company.

A blue arrow pointing up representing an increase in the p/e ratio.

What Is the P/E Ratio?

The P/E ratio measures the relationship between a stock’s price and its earnings, or profits, per share. This is important to investors because a company’s earnings help drive an investor’s return on investing in the stock.

When a company generates significant earnings, over the long term this well help drive the price of a stock higher. This provides a return to investors who buy the stock at a lower price and then sell it at its higher price.

Earnings can also be distributed to investors as dividends. The dividend distributions to shareholders count as income paid out to shareholders, which also represents a return on their investment.

How to Calculate P/E Ratio

Here is how to calculate a stock’s P/E ratio:

P/E equals price per share divided by earnings per share (EPS).

This formula takes a company’s current stock price and divides it by its last 12 months of earnings per share. This is a trailing P/E because it is looking backward at previous earnings.

Let’s look at Coca-Cola (NYSE: KO), for example. This stock is currently set to open on November 5, 2020, at a price of around $49.91. Let’s round this number up and say the stock is currently trading at $50.

The company’s earnings per share over the past year is $1.93. Let’s round that up to $2 per share to make it easier. In order to calculate the company’s EPS in this example, we divide $50 by $2, which equals 25.

In other words, Coca-Cola is trading at 25 times its earnings. Is this a good P/E ratio? Should you invest in the stock? Well, that depends…

Everyone wants more earnings for every dollar they invest. So in theory, a lower P/E is considered more attractive. But this is not always the case. Here’s why.

What Does The P/E Ratio Tell You?

The P/E ratio gives us a clue as to what the market is willing to pay for a company’s earnings. The higher the P/E, the more the market is willing to pay for the company’s earnings – and vice versa.

Some investors interpret a relatively high P/E as overpriced. The best gauge of whether a P/E is high or not is to compare it to similar industry competitors. On the flip side, the market may be bullish about the company’s future and bid up the stock price, leading to a higher P/E.

A company with a relatively low P/E may be overlooked or ignored by the market. This is the ideal prize for value shoppers. But this same position could mean that the market has driven the stock price down because the company just has bad fundamentals.

Why The Ratio Paints an Incomplete Picture for Investors

The P/E ratio paints an incomplete picture. Here’s why:

  1. The P/E ratio usually looks backward. Let’s say one company is able to double its earnings in a few short years while another remains stagnant. The former could be a much better value despite a higher multiple because of its high growth rate. Yet you wouldn’t know this from the single-snapshot picture the P/E provides.
  2. The “forward P/E” published by some sources is a better tool. This is because it uses the next year’s expected earnings instead of last year’s earnings. It is forward-looking. But this picture is still limited since it’s just an educated guess at next year’s earnings and could definitely be wrong.
  3. Also, remember that accountants can do some creative things with reported earnings. While one company may report a largely honest number, another may be manipulating earnings per share to meet market expectations. As a result, the P/E ratio could be painting a misrepresentation of the company’s true value on the market.

The Lesson to Be Learned 

First of all, P/E ratios need to be placed in a context that gives them meaning in which they’re compared to competitive companies or to an industry average. They mean little isolated from this context.

And maybe most importantly, the P/E ratio should never be the only metric used when trying to determine whether a company is currently overvalued or undervalued. It doesn’t matter if it’s a trailing or a forward P/E. No ratio should be used in isolation for that matter.

The metric becomes more useful if you can get a grasp on just how much in earnings a company will be able to achieve over the coming years. But in order to do this, you’ll need to study the underlying business and understand its margins, scalability and competitive position within the industry.

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So, simply put, the P/E ratio is a helpful metric. But don’t make the common amateur mistake of letting it be a be-all and end-all valuation metric.