P/E Ratio: What Is It?

The price-to-earnings ratio, or P/E is the ratio of the market price of a company’s stock to its earnings per share (EPS):

P/E Ratio =	Market Value per Share
	Earnings per Share (EPS)

Many times, investors look to the past four quarters of earnings and calculate annual earnings per share. This is known as the trailing P/E.

If a company’s shares are trading at $20 and it’s earnings per share was $1.25 over the past year, the trailing P/E would be 16x. The P/E is often expressed a multiple of earnings. Notice that the P/E ratio is not expressed in dollar terms – this is because the dollar terms in the numerator and denominator of the P/E ratio formula cancel each other out. This leaves us with an apples to apples comparison with other companies' P/Es. If a second company in the same industry was trading with a P/E of 10x, an analyst would have to determine if one was overpriced relative to the other.

Sometimes, analysts are interested in long term valuation trends and consider the P/E 10 or P/E 30 measures, which average the past 10 or past 30 years of earnings, respectively. These measures are often used when trying to gauge the overall value of a stock index, such as the S&P 500 since these longer term measures can compensate for changes in the business cycle. The P/E ratio of the S&P 500 has fluctuated from a low of around 6x (in 1949) to over 120x (in 2009). The long-term average P/E for the S&P 500 is around 15x, meaning that the stocks that make up the index collectively command a premium 15 times greater than their weighted average earnings.

The trailing P/E ratio will change as the price of a company’s stock moves, since earnings are only released each quarter while stocks trade day in and day out. As a result, some investors prefer the “forward” or leading P/E. The forward P/E ratio is similar to the trailing, but uses estimates of projected future earnings, typically forecast over the next twelve months. If the forward P/E ratio is lower than the trailing P/E ratio, it means analysts are expecting earnings to increase; if the forward P/E is higher than the current P/E ratio, analysts expect a decrease in earnings.

Companies that aren't profitable, and consequently have no earnings – or negative earnings per share, pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E, others assign a P/E of 0, while most just say the P/E doesn't exist or is not interpretable until a company becomes profitable for purposes of comparison.

A variation on the forward P/E ratio is the price-to-earnings-to-growth ratio, or PEG. The PEG ratio is calculated as a company’s trailing price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock's value based on trailing earnings while also taking the company's future earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. For example, a low P/E ratio may suggest that a stock is undervalued and therefore should be bought – but factoring in the company's growth rate to get its PEG ratio can tell a different story. PEG ratios can be termed “trailing” if using historic growth rates or “forward” if using projected growth rates.