P/E and Forward P/E

The price to earnings ratio (P/E) is the most widely quoted valuation measure. It shows how many dollars investors pay for each dollar of a company's annual earnings. A P/E of 20 means the stock costs 20 times its earnings per share. The forward P/E uses expected earnings instead of past earnings. P/E ratios are simple and useful for comparing similar companies, but they can mislead when earnings are depressed, inflated or distorted by accounting.

The formulas#

P/E = share price / earnings per share
earnings yield = EPS / share price = 1 / P/E

Worked example#

What a high or low P/E can mean#

A low P/E is not automatically a bargain, and a high P/E is not automatically a bubble.

Typical P/E levels#

The S&P 500's long run average trailing P/E has been roughly 15 to 17, though it has spent much of the past two decades higher. Growth sectors such as technology usually trade at higher P/Es than utilities, banks or energy companies. Compare a company's P/E with its own history, its peers and its growth rate. See Comparable Companies and Precedent Transactions and PEG Ratio.

The cyclical trap#

For cyclical businesses such as automakers, chipmakers and commodity producers, P/E can be lowest at the peak of the cycle, when earnings are temporarily high, and highest at the bottom, when earnings collapse. Buying cyclicals on a low P/E at the peak can be costly. Many analysts use mid cycle or normalised earnings instead. See Business and Economic Cycles.

Limits of P/E#

• Negative earnings: P/E is meaningless for loss making companies.
• Debt is ignored: two companies with the same P/E can have very different debt loads. EV/EBITDA accounts for debt. See EV/EBITDA and EV/Sales.
• Accounting distortions: one off gains, impairments and adjusted figures. See Earnings Quality and Cash Conversion.
• Buybacks raise EPS and lower P/E without improving the business. See Buybacks.
• Interest rates: higher rates generally justify lower P/E ratios, since future earnings are discounted more heavily.

P/E and interest rates#

The earnings yield can be compared with bond yields. When the S&P 500's forward earnings yield is 5% and the 10 year Treasury yields 4.5%, the gap (the equity risk premium proxy) is small, suggesting stocks offer limited extra return for their risk. This comparison is sometimes called the Fed model, though its usefulness is debated.

Frequently asked questions#

What is a P/E ratio?#

The share price divided by earnings per share, showing how much investors pay for each dollar of earnings.

What is the difference between trailing and forward P/E?#

Trailing P/E uses the last 12 months of actual earnings; forward P/E uses analysts' estimates of future earnings.

What is a good P/E ratio?#

It depends on growth, risk, industry and interest rates. Compare a stock's P/E with its peers, its own history and its growth rate rather than using a single number.

Next, adjust P/E for growth with the PEG Ratio.