A simple guide to the P/E ratio
Updated: Sep 10
Let's say you just got 100 bucks to invest with on your birthday. After some quick research, you find two companies that both earned $1 in profit per share last year. Company A's share price is $10, and company B's share price is $100. Which one should you buy? If you said ‘duh, obviously the first company; it’s so much cheaper and it earned the same as the other one. What a dumb question!’, then you're in for a bit of a rude awakening. Things are actually a bit more complex than that, but everything ultimately boils down to understanding this metric: the Price-to-Earnings (P/E) ratio. Sounds complicated? This is the full formula:
P/E Ratio = Share Price ÷ Earnings Per Share
Yeah, that's it. Not so bad, right? Not rocket science or anything like that. If a stock trades at $100 and the company earned $5 per share, then its P/E is 20. Easy division. Going back to companies A and B, company A has a P/E of 10 and B has a P/E of 100. But what does the P/E ratio actually represent?
Simply put, the P/E ratio shows roughly how many years it would take a company's profits to pay you back the price you paid for the stock, assuming (unrealistically) that profits will never grow. You could look at a P/E of 10 and interpret it as ‘10 years to earn my money back’. At this point, you might be wondering: okay, but 10 years is still a lot shorter than 100 years, so I don’t see how company A will ever be worse than company B. Well, the thing is that in the real world, profits will almost always grow, and often at disproportionate rates which may even be enough to offset the gap in share price.
So why are investors willing to pay 100 years’ worth of profit for some stocks?
A high P/E isn’t automatically a red flag, and a low P/E doesn’t directly translate to a bargain. As with any other number in finance, it only makes sense once you see it in context. For example, let’s look at Nvidia and Coca-Cola. Nvidia’s P/E is roughly 34, while Coca-Cola’s is roughly 26. However, Nvidia is a vastly more popular and valuable stock than the latter; this is because investors aren’t paying for Nvidia’s current profits, but rather the potential profits that Nvidia will reap in the future. Being a growth-focused technology stock, the likelihood that its earnings will exponentially increase as the AI boom continues to flourish is much higher than the chances that Coca-Cola’s earnings will significantly increase, so investors are willing to pay a premium to cash in on the tech industry’s acceleration. However, for investors with a lower risk appetite and just want a predictable flow of cash, then Coca-Cola might be just what they are looking for.
How to intelligently use the P/E ratio
Now that you know the basics of the P/E ratio, it is crucial to understand how to make use of the information wisely. Here are a few basic tips to keep in mind when assessing stocks based on its P/E ratio:
COMPARE WITHIN THE SAME SECTOR: JPMorgan’s P/E and Meta’s PE are obviously going to differ because both companies are playing different games. Different industries have different growth rates and risk profiles, so what is considered ‘normal’ won’t be likely to match.
COMPARE A COMPANY TO ITS OWN HISTORY: Is this stock’s P/E unusually high compared to its historical values? Why? Did it do something different recently to justify it, or did something happen in the broader market?
ASK WHAT JUSTIFIES THE PRICE: Tesla’s P/E ratio is over 300, which is astronomically larger than the average of its automotive manufacturing counterparts (normally around 10). If they aren’t making flying cars, something else has to be driving that number. Maybe it could be the prediction that they will be the unquestionable future leaders of the robot revolution. Do you believe that prediction?
Things to note
If you Google a stock’s P/E ratio, you will likely find not one but two values attributed to the P/E ratio: forward and trailing P/E. In essence, trailing P/E is used by everything that was discussed above (the share price of the stock divided by the company’s earnings in the past 12 months). However, forward P/E is based on analysts’ predicted earnings for the year ahead. This reveals a few interesting things: if a stock’s forward P/E is much lower than its trailing P/E, you can expect serious earnings growth, and vice versa.
Final thoughts
Today's overall market P/E is roughly 27. When compared against the long-run historical average, which is closer to 19–20, it suggests that the market is pricing in a lot of optimism that still has yet to show up. Whether it will actually materialise or not , only time will tell. As an investor, you must do your homework before making any investment choice: the P/E ratio is extremely helpful but will only reveal so much.
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