P/E Ratio Explained: What It Means and How to Use It Well
Updated: 5 hours ago
The price-to-earnings (P/E) ratio is the share price divided by earnings per share. It tells you how many dollars you pay for each dollar of a company's annual profit, so a P/E of 20 means you pay $20 for every $1 of earnings. It is the most quoted valuation number in investing, and also one of the most misused.
Used well, the P/E is a fast first filter. Used alone, it can talk you into value traps and out of great businesses. This guide shows you how to calculate it, read it in context and avoid the classic mistakes.
Where this fits: the P/E ratio is one of the tools for Criterion 5, Reasonable price. For the full picture of valuation, start with our hub on what stock valuation is and how to value a stock, part of the Five Criteria.
How to Calculate the P/E Ratio
The formula has two versions that give the same answer.
Per share: P/E = share price divided by earnings per share (EPS)
Whole company: P/E = market capitalisation divided by net income
If a stock trades at $50 and the company earned $2.50 per share over the past year, the P/E is 50 divided by 2.50, or 20x. If you need a refresher on the bottom half of that fraction, read what earnings per share (EPS) is.
Neither a high nor a low P/E is good or bad on its own. A low P/E can mean a bargain or a business in decline. A high P/E can mean an overpriced stock or a company whose profits are about to grow quickly. The number is a question, not an answer.
The Earnings Yield: Turning P/E Upside Down
Flip the P/E over and you get the earnings yield: EPS divided by share price. A P/E of 20 is an earnings yield of 5%. A P/E of 10 is 10%. A P/E of 40 is just 2.5%.
P/E ratio | Earnings yield | What $100 invested "earns" per year |
10x | 10.0% | $10.00 |
15x | 6.7% | $6.67 |
20x | 5.0% | $5.00 |
30x | 3.3% | $3.33 |
40x | 2.5% | $2.50 |
I find the yield far more intuitive than the ratio. It lets you compare a stock directly with a savings account or a government bond. If a bond pays 4% with no business risk, a stock with a 2.5% earnings yield needs strong, reliable growth to justify its price.
The earnings yield is also the bridge to our preferred test, the free cash flow yield. Same idea, but using cash rather than accounting profit.
Trailing P/E vs Forward P/E
You will see two versions on most financial websites.
Trailing P/E uses actual reported earnings for the past twelve months. It is based on real numbers, so it is the more reliable anchor.
Forward P/E uses analysts' estimates of earnings for the next twelve months. It reflects expectations, which are often too optimistic.
When the forward P/E is well below the trailing P/E, analysts expect earnings to rise. When it is higher, they expect earnings to fall, and that is worth investigating.
My rule is simple. Anchor on the trailing figure and treat the forward figure as the market's hopes. Having worked in investor relations, I know how much effort goes into shaping expectations. Reported results are what you can actually check.
What about the Shiller P/E (CAPE)?
Economist Robert Shiller popularised the cyclically adjusted P/E, often called CAPE. It divides price by the average of ten years of inflation-adjusted earnings. It is mostly used for whole markets rather than single stocks.
The useful lesson for individual stocks is the same: one year of earnings can mislead. Averaging over several years gives a truer picture of what a business normally earns.
How to Tell if a P/E Is High or Low
A P/E only means something when you compare it with the right benchmark. Use three comparisons.
The company's own history. Is it trading above or below its typical P/E over the past five to ten years? If it is well below, ask whether something has broken or whether the market is simply gloomy.
Close peers. Compare with businesses of similar quality, growth and risk in the same industry. A software company and a utility should not be compared on P/E.
What growth the price implies. At 30x earnings, what growth rate would you need to earn a decent return? Is that growth realistic?
Benjamin Graham gave defensive investors a hard ceiling in The Intelligent Investor: generally no more than 15 times average earnings of the past three years. That rule was designed for cautious investors in large, established companies, and it is stricter than we need. But the principle behind it, using averaged earnings and capping what you pay, still holds.
Peter Lynch took a growth-aware view in One Up On Wall Street. He argued that a fairly priced company's P/E roughly equals its growth rate. That idea became the PEG ratio: P/E divided by growth. It is useful, but only as good as the growth forecast behind it.
Worked Example: Two Companies, Same P/E
Here are two clearly hypothetical businesses. Both trade at a P/E of 15. On the surface, they look equally priced.
Company A | Company B | |
Share price | $30 | $30 |
Earnings per share | $2.00 | $2.00 |
P/E | 15x | 15x |
Free cash flow per share | $2.10 | $0.80 |
Net debt per share | $0 (net cash) | $15 |
Now look beneath the P/E.
Company A converts more than all of its profit into free cash flow. Its price-to-free-cash-flow is about 14x, a free cash flow yield of 7%. It has no net debt.
Company B turns only 40% of its profit into cash. Its price-to-free-cash-flow is 37.5x, a free cash flow yield of about 2.7%. It also carries $15 of net debt for every $30 share.
Company A may be good value. Company B only looks cheap because the P/E ignores both its weak cash conversion and its debt. Once you add the debt, an owner of Company B is effectively paying far more for each dollar of real cash.
This is exactly why the P/E is a starting point, never the verdict.
How We Use the P/E Ratio in the Five Criteria
The Five Criteria does not use the P/E as its pass or fail test for price. Our Criterion 5 default is:
Free cash flow yield of 5% or more, or
A price at least 25% below a conservative intrinsic value from a DCF.
So where does the P/E fit? We use it in three ways.
As a screen. A trailing P/E above about 30 means an earnings yield under 3.3%. It is unlikely such a stock offers a 5% free cash flow yield unless cash flow is well above profit. That tells you where not to spend time.
As a quality cross-check. Compare the earnings yield with the free cash flow yield. Criterion 1 asks for free cash flow of at least 90% of net income. If the FCF yield is far below the earnings yield, the profits are not turning into cash.
As a mood gauge. Tracking a company's P/E against its own history shows when Mr. Market is unusually optimistic or pessimistic about a business you already like.
Remember that price is the last of the five questions. A low P/E never rescues a company that fails on business quality, moat, management or balance sheet. For the cash-based test we actually use, read our guide to price to free cash flow and FCF yield.
Common P/E Ratio Mistakes
1. Buying cyclicals at a low P/E
Miners, energy producers, chemical makers, airlines and car makers often show their lowest P/E at the top of the cycle, when profits are temporarily high. That can be exactly the wrong time to buy. Their P/E often looks highest at the bottom, when profits have collapsed. Normalise earnings across a full cycle first.
2. Ignoring one-off items
A large gain from selling a division can inflate one year's earnings. A big write-down can crush them. Either way the P/E is distorted. Read the income statement and strip out items that will not repeat.
3. Ignoring debt
The P/E only looks at equity. Two companies at the same P/E can carry wildly different debt, as the example above showed. Cross-check with enterprise value and our balance sheet criterion.
4. Comparing across very different industries
A bank, a utility and a software business have different growth, risk and capital needs. Comparing their P/E ratios directly is like comparing house prices in a city centre and a rural village by the square foot.
5. Treating a high P/E as automatically expensive
A business that can reinvest at high returns for many years may be worth a higher multiple. The question is not "is the P/E high?" but "what growth am I paying for, and how likely is it?" If the answer requires everything to go right, that is overpaying. See when is a stock cheap? A practical framework.
6. Forgetting negative earnings
If a company lost money, the P/E is meaningless or shown as "N/A". That is not a sign of cheapness. It usually means the business sits outside what the Five Criteria can value with confidence.
Frequently Asked Questions
What is a good P/E ratio? There is no universal good number. It depends on the company's growth, quality, debt and industry. As a rough guide, a P/E of 20 equals a 5% earnings yield, and you should then check whether free cash flow supports a 5% free cash flow yield.
Is a lower P/E ratio always better? No. A low P/E can signal a shrinking business, peak-cycle profits or hidden debt. Always check free cash flow and the quality of the business before calling a low-P/E stock cheap.
What is the difference between trailing and forward P/E? Trailing P/E uses actual earnings from the past twelve months. Forward P/E uses analysts' estimates for the next twelve months. Trailing is more reliable because it is based on reported numbers.
Why do growth stocks have high P/E ratios? Investors pay more today for earnings they expect to grow quickly. That can be justified if the growth arrives, but it leaves little room for error if it does not.
Your Next Step
Take a stock on your watchlist and calculate three numbers: its trailing P/E, its earnings yield and its free cash flow yield. If the last two are far apart, find out why before going further.
Then read our stock valuation hub to see how the P/E fits alongside price to book value and DCF, or check your inputs with our investment calculators.
About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.
The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.
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