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Financial 101 - P/E ratios

Financial 101 - P/E ratios

February 25, 2016
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When reading about investments or listening to cable news you'll run across lots of terms. It can be difficult to follow the conversation if you don't understand what the jargon means. Our Financial 101 series will provide definitions for common investment jargon and cover various financial planning topics. Please share with us if you find it helpful.

A common term in investing is the P/E ratio or Price-to-Earnings Ratio. This ratio is used for valuing a company.  It measures the current share price relative to the per-share earnings. The price-earnings ratio can be calculated as:

    Market Value per Share / Earnings per Share 

For example, suppose that a company is currently trading at $44 a share and its earnings over the last 12 months were $2 per share. The P/E ratio for the stock could then be calculated as 44/2 or 22.

A P/E ratio is one way to compare two different stocks. A high P/E ratio indicates that investors expect higher earnings growth in the future as compared to companies with a lower P/E. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends. When a company has no earnings or is posting losses, in both cases P/E will be expressed as “N/A.” Though it is possible to calculate a negative P/E, this is not the common convention.

The average P/E ratio of the S&P 500 over time has been around 16.  The S&P 500 is an index that is comprised of the 500 largest public companies in the United States and is often used as a benchmark.  When the P/E ratio of the broad market trends higher than the historical average of 16, it means that prices are rising faster than earnings. If the P/E ratio continues to go higher, it could mean that prices have risen too high and are due for a drop. Experts vary in their analysis of how high is "too high" and investors can remain quite exuberant, supporting high P/E ratios for some time before reality crashes in.

The average P/E ratio will vary by sector and by country. Investors are often willing to pay a higher price for stocks in an industry that is expected to grow, such as technology or pharmaceuticals, or for a country that is expected to grow more than other areas of the world.

While P/E ratios are a helpful measure, there are a few important limitations that are important to take into account. Investors are often led to believe that there is one single measure or algorithm  that will provide complete insight into an investment decision. This is not the case. For example, a company that has taken on debt in order to expand may show higher earnings per share and thus a lower P/E ratio than a similar company which has not taken on debt. The company with the lower P/E ratio may look like a better bargain, but if they can't pay back the debt, the company will be in serious trouble and the stock price will take a beating.  A savvy investor will consider many different factors before making a decision to buy or sell.

Read more about P/E ratios and other measures used in investing on Investopedia.com. We thank them for providing content for this blog.