Using the Price to Earnings Ratio and PEG to Assess a Stock

The 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.

The P/E ratio helps investors determine the 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.

What Is a P/E Ratio?

Companies that grow faster than average, such as technology companies, typically have higher P/Es. A higher P/E ratio shows that investors are willing to pay a higher share price now due to growth expectations in the future. The median P/E for the S&P 500 was 14.93 as of May 2023.

Investors not only use the P/E ratio to determine a stock's market value but also in determining future earnings growth. Investors might expect the company to increase its dividends as a result if earnings are expected to rise. Higher earnings and rising dividends typically lead to a higher stock price.

Formula and Calculation of the P/E Ratio

The 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.

Earnings 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’s 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 “E” or earnings portion of the P/E valuation ratio.

Analyzing P/E Ratios

A stock should be compared to other stocks in its sector or industry group to determine whether it's overvalued or undervalued. Similar companies should be compared to each other, like insurance to insurance or oil producer to oil producer.

An 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 of slowing the economy and taming inflation to prevent a rapid rise in prices. 

Certain industries do well in this environment. Banks earn more income as interest rates rise because they can charge higher rates on their credit products, such as credit cards and mortgages. Basic materials and energy companies also receive a boost in earnings from inflation because they can charge higher prices for the commodities they harvest.

Interest 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.

Limitations to the P/E Ratio

The 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.

Volatile Market Prices

Volatile market prices can throw off the P/E ratio, but this more commonly happens in the short term. 

Earnings Makeup of a Company

The earnings makeup of a company is often difficult to determine. The P/E is typically calculated by measuring historical earnings or trailing earnings, but historical earnings aren't of much use to investors because they reveal little about future earnings.

Forward 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.

One-time adjustments such as the sale of a subsidiary could inflate earnings in the short term. This complicates the predictions of future earnings because the influx of cash from the sale wouldn't be a sustainable contributor to earnings in the long term. Forward earnings can be useful, but they're prone to inaccuracies.

Earnings Growth

Earnings 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.

It can be difficult to tell if a high P/E multiple is the result of expected growth or if the stock is simply overvalued.

The PEG Ratio

A 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.

The PEG ratio allows investors to calculate whether a stock's price is overvalued or undervalued by analyzing both today's earnings and the expected growth rate for the company in the future.

Example of a PEG Ratio

An 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.

These 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,

The Bottom Line

The price to earnings ratio (P/E) is one of the most common ratios used by investors to determine if a 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. 

The P/E ratio doesn't factor in future earnings growth, so the PEG ratio provides more insight into a stock's valuation. The PEG is a valuable tool for investors in calculating a 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 a complete picture of a company's financial health and its stock valuation.

Every investor wants an edge in predicting a company's future, but a company's earnings guidance statements may not be a reliable source.