P/E ratios: what they are, how to use them and examples

When you’re trying to figure out if a particular stock is a good investment, the P/E ratio can help you with that decision. It can help you gauge whether the price is low or high compared to other options in the same sector, and it can indicate the future direction of the stock. When taking into account a company’s underlying earnings power and overall growth rate, the P/E ratio is one of the simplest ways to determine whether a stock is worth trading. In this article, we discuss what the P/E ratio is, why you should use it, the P/E ratio formula, how to use the formula and give an example.

What is the P/E ratio?

The P/E ratio, or price to earnings ratio, is used to show the relationship between earnings per share (EPS) and a company’s share price. It measures the share price relative to the annual net profit earned per share. When a P/E ratio is high, it indicates that investors’ current demand for a company’s stock is increasing because investors expect future earnings growth. Using the P/E ratio can show how much investors are willing to pay for a dollar of income. This popular ratio can help show the value of a company to investors.

Why should you use the P/E ratio?

A good return on investment (ROI) is important for investors who want to buy financially secure companies. Often, the P/E ratio is part of the research process for selecting stocks so investors can determine if they are paying a fair price. It can also be used to compare similar companies in the same sector, even if share prices vary. The P/E ratio is easy and quick to use to assess the value of a company’s earnings or when choosing which type of company stock to hold.

High P/E vs low P/E

When a company has a high P/E ratio, it shows the potential for positive future performance and investors often consider it a growth stock. Investors can have high expectations when there is a high P/E ratio and are therefore willing to pay more for the shares. Sometimes when there is a high P/E ratio, it also means that these stocks are volatile and can be a risky investment or overvalued. When a company has a low P/E ratio, it shows that the stock price is trading low relative to its fundamentals. Investors consider these stocks to be value stocks and they are often undervalued, making them a good bargain for investors to buy before the market corrects itself. Investors benefit because they buy the shares at a low price, and then they get back a higher share value. You can find low P/E ratios in mature industries that have a consistent dividend.

Formula for P/E ratio

The units used with the P/E ratio are years because it can show how many years it takes in profit to pay back the purchase price. The P/E ratio formula uses EPS, which is found by dividing the weighted average of outstanding shares by the last 12 months. The formula also uses the current share prices. Sometimes you can calculate P/E ratios by using an estimate of the coming year’s share prices, and it includes a notation to indicate this. The P/E ratio formula is:P/E ratio = P ÷ EPSWhere:P = PriceEPS = Earnings per share.

How to use the P/E ratio

The following steps will show you how to use the P/E ratio:

1. calculate the P/E ratio

For each share, you can use the P/E ratio to calculate the company’s ratio yourself or you can search the internet for the company’s P/E ratio. If you want to calculate the P/E ratio yourself, take the share price of the stock and divide it by the earnings per share. The P/E ratio formula looks like this: P/E ratio = Price ÷ Earnings per share

2. understanding the numbers

The resulting numbers you get from calculating the P/E ratio yourself, or looking it up on the internet, tell you how much you will pay for each dollar the company earns. For example, if stock A has a P/E ratio of $10 and stock B has a P/E ratio of $30, that means investors are willing to pay $10 and $30 respectively for every dollar the company earns.

3. Compare the figures

It is most useful to have several P/E ratios to compare. You can compare current P/E ratios to each other, to past P/E ratios for the same company or to P/E ratios for other companies in the same sector. When comparing P/E ratios of companies in the same industry, it may be beneficial to choose stocks with lower P/E ratios, meaning they are undervalued. When comparing P/E ratios with past data for a particular company, a higher P/E ratio may mean that the stock is no longer a good bargain.

P/E ratio example

The following is an example of how to use the P/E ratio to determine which stock is a more valuable buy: If two stocks are trading, stock X for $30 and stock Y for $20, the P/E formula can help you determine which stock is cheaper from a valuation perspective. Suppose the average P/E ratio for stocks in that industry is $15. When you apply the P/E ratio to stock X, you will calculate that it has an average of $15. When you apply the P/E ratio to stock Y, you will calculate that it has an average of $30. This valuable information shows you that even though stock X has a higher absolute price, you will actually pay less per $1 of current income. Using the P/E ratio as a financial analysis tool will help guide your decision to buy stock X instead of stock Y.

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