P/E ratios, sometimes called price or earnings multiples, measure a company’s value by comparing the share price against its earnings per share (EPS). Investors can use P/E ratios as one measure of a stock’s relative value.

P/E ratios, explained

The P/E, or price-to-earnings, ratio measures how much investors are willing to pay per $1 of company earnings. For instance, if a company trades at 15x earnings, then investors will pay $15 per share for every $1 the company earns.

Calculating the P/E ratio

The “P” in P/E ratio stands for the current market price of a single share of stock. “E” stands for EPS, or the company’s 12-month earnings divided by the average number of outstanding shares.

To calculate a company’s P/E ratio, simply divide P (share price) by E (earnings per share).

For instance, say that Company X trades at $100 and its current EPS is $10. The P/E ratio would be 10x ($100/$10), signifying that investors will pay $10 for every $1 Company X earns.

Types of P/E ratios

You can calculate several types of P/E ratios, including:

• Trailing twelve month (TTM) ratios, which measure a company’s P/E ratio over the last year. Unfortunately, past performance doesn’t guarantee future results. 
• Forward P/E ratios, which measure the expected net earnings for the coming year. The drawback is that there’s no guarantee the company will perform as expected. 
• CAPE or Shiller P/E ratios, which measure a company’s average inflation-adjusted earnings over the last ten years. Shiller P/E ratios are often applied to the S&P 500 index. 

Another variation is the PEG (price-to-earnings to growth) ratio. The PEG ratio measures a company’s value based on current and future expected earnings. However, its major downside is that it relies on future growth that may never materialize.

What this means for you

P/E ratios are useful because they offer a standardized method of comparing stocks across prices and earnings levels. Investors and analysts often use P/E ratios to determine a stock’s relative valuation and inform whether it’s over- or under-valued.

For example, companies with high P/E ratios have high share prices compared to earnings. These companies may be overvalued, or simply growth stocks on their way up. By contrast, companies with low P/E ratios have low share prices compared to earnings. These may be undervalued value stocks, or simply poorly-performing firms.

One important note for using P/E ratios is that they’re most accurate when comparing companies in the same industry. Each industry has a “normal” P/E range that may differ greatly from another’s.

For instance, if you compared AT&T and Exxon’s P/E ratios, you might think one is the clear “winner.” But the reality may simply be that they’re different, not better.

P/E ratios offer a standardized method for comparing stocks or funds with different prices, EPS levels and market caps. But it’s not a perfect measurement – and you shouldn’t rely on a single ratio to inform your trading decisions.

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