The price to earnings ratio (P/E or PE ratio) is a quick way to see if a stock might be overpriced.
It is also a great tool to compare different stocks.
Let's take a deeper look at what the PE ratio is and how to use it.
What is a PE Ratio
The P/E ratio is a calculation that tells you what an investor is willing to pay for a companies earnings.
Specifically what they are willing to pay for $1 of earnings. Thus if the ratio is 15 then the investor will pay $15 for $1 of earnings.
Components of the P/E Ratio & How to Calculate
In this ratio, the 'P' stands for price. The 'E' stands for earnings.
The formula is price of the stock divided by earnings. Stock Price/Earnings = PE Ratio.
When looking at earnings there are two numbers that are used for the calculation. The trailing and forward earnings.
The trailing earnings are the previous 12 months of earnings from a company. The forward earnings are an estimate for the upcoming 12 months.
Luckily you don't need to worry about digging through numbers to calculate the PE ratio. Most financial sites will already have that for you.
You just need to make sure that you know which PE version you are looking at. Most sites will give you both and label them.
To give you an idea of what you are looking for, see the screenshots below for PE ratio information for FEDEX on Morningstar and Yahoo Finance.
(There can be differences in the ratio between sites. This is due to the timing on how often a site will update their numbers.)
What to Look for in a PE Ratio
There are three main things to take into consideration when looking at a stocks pe ratio.
PE Reversion to the Mean
There is a concept in stocks that says overtime the price of an asset will revert to the mean. This concept can be applied to the PE ratio since it has the price in the calculation.
Since the 1870's the average PE ratio has been about 16.7. This number has been drifting higher, but still stands around 20.
This is seen perfectly in this graph from Macro trends.
Keep this in mind when the entire market is starting to get more expensive. You should be even more cautious with what you buy.
Type of Company
How quickly a company is growing will play into how high you are willing to let the PE ratio go.
If it is a growth company in a growing industry then most investors will pay more for the earnings. An example might be a tech company.
If the company is in a stable sector that does not drastically grow investors won't pay as much for earnings. An example might be a utility company.
You will also want to look at what other stocks in the same industry have for a PE ratio. You may be able to secure a better value with a different company.
Final Thoughts & Cautions
- The PE ratio is just one number to look at when picking stocks. It should be used to compare other companies. Additionally the higher the PE is the more you need to look at a companies growth rates.
- During times of recession the PE ratio can be way off. This is due to either prices or earnings not keeping pace with each other.
- Everyone has a different comfort level with what they are willing to pay for a stock. Find what PE ratio level you are comfortable with and use that as your guide.