P/E Ratio Definition: Price-to-Earnings Ratio Formula and Examples

What Is the Price-to-Earnings (P/E) Ratio?

The price-to-earnings (P/E) ratio measures a company's share price relative to its earnings per share (EPS). Often called the price or earnings multiple, the P/E ratio helps assess the relative value of a company's stock. It's handy for comparing a company's valuation against its historical performance, against other firms within its industry, or the overall market.

P/E can be estimated on a trailing (backward-looking) or forward (projected) basis.

P/E Ratio Formula and Calculation

The formula and calculation are as follows:

$\text{P/E Ratio} = \frac{\text{Market value per share}}{\text{Earnings per share}}$P/E Ratio=Earnings per shareMarket value per share​

To determine the P/E value, divide the stock price by the EPS.

The stock price (P) can be found simply by searching a stock’s ticker on a reputable financial website. Although this concrete value reflects what investors currently pay for the stock, the EPS is related to earnings reported at different times.

EPS is generally given in two ways. Trailing 12 months (TTM) represents the company's performance over the past 12 months. Another is found in earnings releases, which often provide EPS guidance. This is the company's advice on what it expects in future earnings. These different versions of EPS form the basis of trailing and forward P/E, respectively.

Understanding the P/E Ratio

The P/E ratio is one of the most widely used by investors and analysts reviewing a stock's relative valuation. It helps to determine whether a stock is overvalued or undervalued. A company's P/E can also be benchmarked against other stocks in the same industry or against the broader market, such as the S&P 500 Index.

Analysts interested in long-term valuation trends can look at the P/E 10 or P/E 30 measures, which average the past 10 or 30 years of earnings. These measures are often used when trying to gauge the overall value of a stock index, such as the S&P 500, because these longer-term metrics can show overall changes through several business cycles.

The P/E ratio of the S&P 500 going back to 1927 has had a low of 5.9 in mid-1949 and been as high as 122.4 in mid-2009, right after the financial crisis. The long-term average P/E for the S&P 500 is about 17.6, meaning that the stocks that make up the index have collectively been priced at more than 17 times greater than their weighted average earnings. This average can serve as a benchmark for whether the market is valued higher or lower than historical norms.

Forward Price-to-Earnings

The most commonly used P/E ratios are the forward P/E and the trailing P/E. A third and less typical variation uses the sum of the last two actual quarters and the estimates of the following two quarters.

The forward (or leading) P/E uses future earnings guidance rather than trailing figures. Sometimes called "estimated price to earnings," this forward-looking indicator helps compare current earnings to future earnings and can clarify what earnings will look like without changes and other accounting adjustments.

However, there are problems with the forward P/E metric—namely, companies could underestimate earnings to beat the estimated P/E when the next quarter's earnings arrive. Furthermore, external analysts may also provide estimates that diverge from the company estimates, creating confusion.

Trailing Price-to-Earnings

The trailing P/E relies on past performance by dividing the current share price by the total EPS for the previous 12 months. It's the most popular P/E metric because it's thought to be objective—assuming the company reported earnings accurately. But the trailing P/E also has its share of shortcomings, including that a company’s past performance doesn’t necessarily determine future earnings.

Investors often base their purchases on potential earnings, not historical performance. Using the trailing P/E ratio can be a problem because it relies on a fixed earnings per share (EPS) figure, while stock prices are constantly changing. This means that if something significant affects a company's stock price, either positively or negatively, the trailing P/E ratio won't accurately reflect it. In essence, it might not provide an up-to-date picture of the company's valuation or potential.

The trailing P/E ratio will change as the price of a company’s stock moves because earnings are released only each quarter, while stocks trade whenever the market is open. As a result, some investors prefer the forward P/E. If the forward P/E ratio is lower than the trailing P/E ratio, analysts are expecting earnings to increase; if the forward P/E is higher than the current P/E ratio, analysts expect them to decline.

Valuation From P/E

In addition to indicating whether a company’s stock price is overvalued or undervalued, the P/E ratio can reveal how a stock’s value compares with its industry or a benchmark like the S&P 500.

The P/E ratio indicates the dollar amount an investor can expect to invest in a company to receive $1 of that company’s earnings. Hence, it’s sometimes called the price multiple because it shows how much investors are willing to pay per dollar of earnings. If a company trades at a P/E multiple of 20x, investors are paying $20 for $1 of current earnings.

The P/E ratio also helps investors determine a stock’s market value compared with the company’s earnings. That is, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E ratio could signal that a stock’s price is high relative to earnings and is overvalued. Conversely, a low P/E could indicate that the stock price is low relative to earnings. 

Examples of the P/E Ratio

Let's clarify this with an example, looking at FedEx Corporation (FDX). We can calculate the P/E ratio for FDX as of Feb. 9, 2024, when the company's stock price closed at $242.62. The company's earnings per share (EPS) for the trailing 12 months was $16.85.

Therefore, FDX's P/E ratio was as follows:

$242.62 / $16.85 = 14.40

Comparing Companies Using P/E

Let's now look at two energy companies to see their relative values.

Hess Corporation (HES) had the following data at the close of Feb. 9, 2024. We'll use the diluted EPS to account for what would occur should all convertible securities be exercised:

• Stock price: $142.07
• Diluted 12 months trailing EPS: $4.49
• P/E: 31.64 ($142.07 / $4.49)

HES thus traded at about 31 times trailing earnings. However, the P/E of 31 isn't helpful unless you have something to compare it with, like the stock's industry group, a benchmark index, or HES's historical P/E range.

HES's P/E ratio was higher than the S&P 500, which, as of Feb. 9, 2024, was about 22 times 12-month trailing earnings. To compare HES's P/E ratio to a peer, let's look at Marathon Petroleum Corporation (MPC):

• Stock price: $169.97
• Diluted 12 months trailing EPS: $23.64
• P/E: 7.19

When you compare HES's P/E of 31 to MPC's of 7, HES's stock could appear substantially overvalued relative to the S&P 500 and MPC. Alternatively, HES's higher P/E might mean that investors expect much higher earnings growth in the future than MPC.

However, no ratio can tell you everything you need about a stock. Before investing, it's wise to use various financial tools to determine whether a stock is fairly valued.

Investor Expectations

In general, a high P/E suggests that investors expect higher earnings growth than those with a lower P/E. A low P/E can indicate that a company is undervalued or that a firm is doing exceptionally well relative to its past performance. When a company has no earnings or is posting losses, the P/E is expressed as N/A. Though it's possible to calculate a negative P/E, it's not common.

The P/E ratio can also standardize the value of $1 of earnings throughout the stock market. In theory, by taking the median of P/E ratios over a period of several years, one could formulate something of a standardized P/E ratio, which could then be seen as a benchmark and used to indicate whether a stock is worth buying.

P/E vs. Earnings Yield

The inverse of the P/E ratio is the earnings yield (which can be thought of as the earnings/price ratio). The earnings yield is the EPS divided by the stock price, expressed as a percentage.

If Stock A is trading at $10, and its EPS for the past year is 50 cents (TTM), it has a P/E of 20 (i.e., $10 / 50 cents) and an earnings yield of 5% (50 cents / $10). If Stock B is trading at $20 and its EPS (TTM) is $2, it has a P/E of 10 (i.e., $20 / $2) and an earnings yield of 10% ($2 / $20).

The earnings yield is not as widely used as the P/E ratio. Earnings yields are useful if you're concerned about the rate of return on investment. For equity investors who earn periodic investment income, this may be a secondary concern. This is why many investors may prefer value-based measures like the P/E ratio or stocks.

The earnings yield is also helpful when a company has zero or negative earnings. Since this is common among high-tech, high-growth, or startup companies, EPS will be negative and listed as an undefined P/E ratio (denoted as N/A). If a company has negative earnings, however, it would have a negative earnings yield, which can be used for comparison.

P/E vs. PEG Ratio

A P/E ratio, even one calculated using a forward earnings estimate, doesn’t always tell you whether the P/E is appropriate for the company’s expected growth rate. To address this, investors turn to the price/earnings-to-growth ratio, or PEG.

The PEG ratio measures the relationship between the price/earnings ratio and earnings growth to give investors a complete picture. Investors use it to see if a stock’s price is overvalued or undervalued by analyzing earnings and the expected growth rate for the company. The PEG ratio is calculated as a company’s trailing price-to-earnings (P/E) ratio divided by its earnings growth rate for a given period.

Since it’s based on both trailing earnings and future earnings growth, PEG is often viewed as more informative than the P/E ratio. For example, a low P/E ratio could suggest a stock is undervalued and worth buying. However, including the company’s growth rate to get its PEG ratio might tell a different story. PEG ratios can be termed “trailing” if using historical growth rates or “forward” if using projected growth rates.

Although earnings growth rates can vary among different sectors, a stock with a PEG of less than one is typically considered undervalued because its price is low relative to its expected earnings growth. A PEG greater than one might be considered overvalued because it suggests the stock price is too high relative to the company’s expected earnings growth.

Absolute vs. Relative P/E

Analysts also distinguish between absolute P/E and relative P/E ratios in their analyses.

Absolute P/E

The numerator of this ratio is usually the current stock price, and the denominator may be the trailing EPS (TTM), the estimated EPS for the next 12 months (forward P/E), or a mix of the trailing EPS of the last two quarters and the forward P/E for the next two quarters.

When distinguishing absolute P/E from relative P/E, remember that absolute P/E represents the P/E of the current period. For example, if the stock price today is $100 and the TTM earnings are $2 per share, the P/E is 50 = ($100 / $2).

Relative P/E

The relative P/E compares the absolute P/E to a benchmark or a range of past P/Es over a relevant period, such as the past 10 years. The relative P/E shows what portion or percentage of the past P/Es that the current P/E has reached. The relative P/E usually compares the current P/E value with the highest value of the range. Investors might also compare the current P/E to the bottom side of the range, measuring how close the current P/E is to the historic low.

The relative P/E will have a value below 100% if the current P/E is lower than the past value (whether the past high or low). If the relative P/E measure is 100% or more, this tells investors that the current P/E has reached or surpassed the past value.

Limitations of Using the P/E Ratio

Like any other fundamental metric, the price-to-earnings ratio comes with a few limitations that are important to understand. Companies that aren't profitable and have no earnings—or negative earnings per share—pose a challenge for calculating P/E. Views among analysts vary about 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 (N/A) until a company becomes profitable.

A main limitation of using P/E ratios is for comparing the P/E ratios of companies from varied sectors. Companies' valuation and growth rates often vary wildly between industries because of how and when the firms earn their money.

As such, one should only use P/E as a comparative tool when considering companies in the same sector because this is the only kind that will provide worthwhile results. For example, comparing the P/E ratios of a telecommunications company and the P/E of an oil and gas drilling company could suggest one is the superior investment, but that's not a cogent conclusion. An individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.

Other P/E Considerations

Because a company’s debt can affect both share price and earnings, leverage can skew P/E ratios as well. For example, suppose two similar companies differ in the debt they hold. The firm with more debt will likely have a lower P/E value than the one with less debt. However, if the business is solid, the one with more debt could have higher earnings because of the risks it has taken.

Another critical limitation of price-to-earnings ratios lies within the formula for calculating P/E. P/E ratios rely on accurately presenting the market value of shares and earnings per share estimates. The market determines the prices of shares available in many places. However, the source of earnings information is the company itself. Thus, it’s possible it could be manipulated, so analysts and investors have to trust the company’s officers to provide genuine information. The stock will be considered riskier and less valuable if that trust is broken.

To reduce these risks, the P/E ratio is only one measurement analysts review. If a company were to manipulate its results intentionally, it would be challenging to ensure all the metrics were aligned in how they were changed. That’s why the P/E ratio continues to be a central data point when analyzing public companies, though by no means is it the only one.

The Bottom Line

The P/E ratio is one of many fundamental financial metrics for evaluating a company. It's calculated by dividing the current market price of a stock by its earnings per share. It indicates investor expectations, helping to determine if a stock is overvalued or undervalued relative to its earnings. The P/E ratio helps compare companies within the same industry, like insurance company to insurance company or telecom to telcom. It offers insights into market sentiment and investment prospects. However, it should be used with other financial measures since it doesn't account for future growth prospects, debt levels, or industry-specific factors.