How to Analyze a Company on Its P/E Ratio

Your co-worker tells you about an enticing stock they read about online and informs you that they’re going to buy shares immediately. The individual investor in you knows that you should always do your research before investing your hard-earned money into a company you know nothing about. You sit down to start your research, but there are countless ways to analyze and evaluate a company. Which one is best?

One of the most common ways to value a company is to look at its price-earnings (P/E) ratio. However, it’s important to know that calculating the P/E ratio is just one of the many ways you can value a company’s stock. We delve into what this specific ratio indicates, how to calculate price-earnings ratio, what a negative P/E ratio means as well as the P/E ratio’s overall limitations.

What Is a P/E Ratio?

The price-earnings ratio (P/E) is arguably the most popular price multiple. There are numerous definitions and variations of the price-earnings ratio. In its simplest form, the price-earnings ratio relates current share price to the firm’s earnings per share (EPS). The higher the ratio, the more investors are paying for each dollar of earnings. For example, if a stock has a price-earnings ratio of 25, it means that investors are paying $25 for each $1 of earnings.

Variations on price-earnings ratios are created by changing the share price used (current or average) and the earnings per share number used (trailing 12 months, expected future, basic versus diluted or continuing). When investors and analysts are referring to a company’s P/E ratio, they are usually discussing the trailing P/E ratio rather than the forward P/E ratio.

How to Use a Price-Earnings Ratio Calculator

The P/E ratio is a fairly simple calculation. You don’t need to use a price-earnings ratio calculator and can determine it easily on your own. The price-earnings ratio calculation is as follows:

Current stock price / earnings per share = company’s P/E ratio

You can find a company’s current stock price by typing its ticker symbol in the search box on AAII.com, and then you can add it a portfolio so you can follow it more closely.

To find a company’s earnings per share, you’ll have to divide the company’s total earnings from the income statement by the total number of outstanding shares, which can be found on the balance sheet. Many websites such as AAII.com show earnings per share on a stock’s financial summary page.

How to Analyze Companies by Their P/E Ratios

The price-earnings ratio is used to gauge the market’s expectation of future performance. Even when using historical earnings, the current price of a stock reflects the market’s belief in future prospects.

Broadly, a high price-earnings ratio means the market believes that the company has strong future growth prospects. A low price-earnings ratio generally means the market has low earnings growth expectations for the firm or there is high risk or uncertainty of the firm actually achieving growth.

However, looking at a price-earnings ratio alone may not be very illuminating. It will always be more useful to compare the price-earnings ratio of one company to that of other companies in the same industry and to that of the market in general.

Furthermore, tracking a stock’s price-earnings ratio over time is useful in determining how the current valuation compares to historical trends.

Do You Want a High or Low P/E Ratio?

If you’re trying to decode what a high or low P/E ratio means, there are two perspectives to consider: the company’s and the investor’s. For the company, a high P/E ratio indicates that investors and analysts are expecting increased growth and revenue compared to companies with a low P/E ratio. Therefore, the company may see a high P/E ratio as signifying expected growth in the near future.

From the investor’s perspective, a high P/E ratio may indicate that the company is extremely overvalued at the present time, which means they should wait to buy the stock. A medium to high P/E ratio is not always a sign of overvaluation, however, so you may want to analyze other Financial Metrics to see if there is misleading data or inconsistencies.

A low P/E ratio might signal undervaluation, or it could indicate that the current stock price is low relative to the firm’s overall earnings. An investor would need to do further research to verify whether this is a good time to buy the stock of a company with a low P/E ratio.

Learn more about how to incorporate the price-earnings ratio into your screening and analysis.

Lastly, it’s important to understand that different types of investors may focus on different Financial Metrics. Value investors seek stocks that are underappreciated or neglected by the majority of investors and therefore look for companies with low P/E ratios when they are choosing which stocks to buy.

What Does a Negative P/E Ratio Mean?

Because the market ebbs and flows, a negative P/E ratio doesn’t necessarily mean a company is failing. If you see a company with a negative P/E ratio, it indicates that the business has negative earnings or is losing money in a specific period of time. However, it’s important to remember that even the most established companies experience down periods and may have a negative P/E ratio from time to time.

A negative earnings per share figure means is that the company had negative net income in the last year —calculated using earnings for the past four fiscal quarters.

Limitations of Using P/E Ratio

The usefulness of any price-earnings ratio is limited to firms that have positive actual and expected earnings. Depending on the data source you use, companies with negative earnings may have a “null” or zero for the P/E. That’s why it is key to check other Financial Metrics whether the stock you are researching has a positive or negative P/E ratio.

In addition, earnings are subject to management assumptions and manipulation more than other income statement items such as sales, making it hard to get a true sense of value. Depending on a company’s accounting procedures, it can be difficult to determine if the P/E ratio is accurate. For example, a company can report positive earnings while having negative free cash flow; this means it is spending more money than it is earning, which will not be accurately reflected in its P/E ratio.

Lastly, comparing P/E ratios from companies in across industries can be challenging. More often than not, companies that are in different industries will have vastly different P/E ratios; this is especially true for stocks in the technology sector—their price-earnings ratios are not comparable to those of stocks in other sectors. Also, the P/E ratio of a small start-up or emerging company may be vastly different than that of a mid- to large-cap company even in the same industry.

Other P/E Meanings in Business

Most P/E meanings in business focus on the trailing P/E ratio, but what about the forward, average and relative P/Es? There are multiple P/E meanings in business that refer to varied forms of the P/E formula. If you’ve seen these terms while researching stocks, you may be curious to know what they mean and how they differ.

What Is the Forward P/E Ratio?

The forward (or estimated) price-earnings ratio calculated using the current stock price and the estimated earnings for future full fiscal years. Depending on how far out analysts are forecasting annual earnings (typically, for the current year and the next two fiscal years), a company can have multiple forward price-earnings ratios.

The forward P/E will change as earnings estimates are revised when new information is released and quarterly earnings become available. Also, forward price-earnings ratios are calculated using estimated earnings based on current fundamentals. A company’s fundamentals could change drastically over a short period of time and estimates may lag the changes as analysts digest the new facts and revise their outlooks.

What Is the Trailing P/E Ratio?

When investors and analysts discuss P/E ratio, they usually are referring to the trailing P/E ratio. Trailing P/E ratio takes the last 12 months into account and is found to be more reliable than the forward P/E ratio since it is based on actual versus expected performance.

You can easily calculate the trailing P/E ratio by dividing the company’s current market value/share price by the earnings per share over the previous 12 months. You may see “trailing 12 months” abbreviated as TTM in stock data tables.

It’s important to remember that even though a company’s trailing P/E ratio is deemed more definite by many investors and analysts, a company’s past earnings over one year are not necessarily an accurate predictor of what it may earn in the future. Like other financial ratios, it’s important to do some research by taking a look at other metrics to determine the value of a stock.

What Is the Average P/E Ratio?

The average price-earnings ratio attempts to smooth out the price-earnings ratio by reducing daily variation caused by stock price movements that may be the result of general volatility in the stock market. Different sources may calculate this figure differently.

Average P/E is often defined as the average of the high and low price-earnings ratios for a given year. The high P/E is calculated by dividing the high stock price for the year by the annual earnings per share fully diluted from continuing operations. The low P/E for the year is calculated using the low stock price for the year. Other sources may use average share price over a given time period.

What Is the Relative P/E Ratio?

The relative price-earnings ratio helps to compare a company’s price-earnings ratio to the price-earnings ratio of the overall market, both currently and historically.

Relative P/E is calculated by dividing the firm’s price-earnings ratio by the market’s price-earnings ratio. Typically, the S&P 500 index is used as a proxy for the market. Keep in mind that the prices and earnings used for the firm and the market should be over the same period.

How to Find Price-Earnings Ratios

No matter which financial website or brokerage account you use, finding a company’s P/E ratio is relatively easy. It may be located in different areas, but the P/E ratio is usually found in the company’s overview or value section. Sometimes trailing P/E ratios will have a dash instead of a number, which could mean that it is too soon (under 12 months) due to it being a new IPO (initial public offering) or emerging company.

On the AAII website, you can search for any stock or other security and easily find the P/E ratio. Scroll down on any stock data page to the section titled Financial Summary. Under the value section, you will find the price-to-book (P/B) ratio, price-to-earnings (P/E) ratio, dividend yield as well as the price-earnings-to-growth (PEG) ratio.

Using the Trailing P/E Ratio to Invest

A company’s price-earnings ratio is a useful tool for examining a firm’s share price relative to its earnings. As with most fundamental analysis, it is important to understand the elements that go into calculating the ratio. To use trailing P/E ratios in a meaningful way, they must be compared to a company’s ratios over time or between industries and similar competitors.

No matter what type of investor you are or what strategies you follow, understanding how to screen for low P/E stocks as well as other key Financial Metrics is important when researching a company you may want to invest in.

You can conveniently add stocks and other securities to your My Portfolio as an AAII member so you can analyze various metrics such as the trailing P/E ratio.