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Price-earnings ratio

The price-earnings ratio or P/E ratio is a fundamental analysis valuation metric that assesses how expensive a company’s share price is based on yearly earnings per share (EPS). Financial ratios such as the P/E ratio help investors to determine whether a stock is overvalued or undervalued, and what levels may be attractive to buy or sell at.

Price-to-earnings is only one metric; as in it aids trading decisions but investors cannot exclusively rely on it. Here we look at how to calculate the P/E ratio, what affects it, how to interpret it, and how it can be used to aid trading decisions within the share market. P/E ratios fluctuate daily since the share price moves most days, and this information is updated daily on our Next Generation trading platform.

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What is the price-to-earnings ratio?

The price-to-earnings ratio is a fundamental analysis tool that is calculated by dividing the current company stock price by yearly earnings per share. Company analysis​ looks at financial ratios and accounting statements to determine how a company is performing and whether or not it may be a good investment.

Not only does the ratio look at the earnings, but it compares it to the stock price. The P/E ratio describes how many years of current earnings the shares are priced at. For example, if yearly earnings per share are $1 and the stock price is $48, the stock is priced at 48 years’ worth of current earnings.

In this article, we discuss what is considered to be a high or low ratio, as this also depends on the company’s growth prospects and future potential earnings. A high or low ratio helps traders to assess whether they want to buy, sell, or wait for a better opportunity.

What is a forward P/E ratio?

Whereas a normal P/E ratio looks at the most recent year for total earnings, a forward P/E ratio is based on the estimated earnings predicted by analysts for the upcoming year. Both ratios are based on the current stock price.

If forward P/E is lower than normal P/E, this means that analysts are expecting earnings growth in the upcoming year. A drastically lower ratio means that a large amount of growth is expected. On the other hand, if forward P/E is higher than normal P/E, analysts are forecasting lower growth prospects for the company.

P/E ratio formulas

P/E ratio = price/earnings

Where:

Price = current share price

Earnings = earnings over past year; total the past four quarterly earnings amounts

Forward P/E ratio = price/forward earnings

Where:

Price = current share price

Forward earnings = expected earnings next year; total the analyst expected earnings for the next four quarters

A business year is not the same as a calendar year; therefore, when calculating past or future earnings, traders and investors often use the prior four quarterly earnings and sum them up to get the total earnings over the past year. Similarly, they could add up the following four quarters of expected earnings to get forward earnings.

Earnings yield is another fundamental analysis ratio. It is the same as P/E but expressed in a different way. Earnings yield is earnings divided by price, expressing earnings for each dollar of price, whereas P/E expresses price for each dollar of earnings.

Example of how to calculate P/E ratio

Let’s look at the technology company Apple Inc. (AAPL)​ as an example of how to calculate P/E, which is also available for spread betting or CFD trading on our platform. Here are the last four earnings amounts as of February 2021:

  • $0.74
  • $0.65
  • $0.64
  • $1.26

These are “earnings per share” – net income divided by the number of shares outstanding.

If we add these amounts together, we get $3.29. Let’s say that the current share price is $125.

125 (price) ÷ 3.29 (earnings) = 38 (P/E ratio)

If the share price was $100, the P/E ratio would be 30. If the price were to spike up to $200 while earnings stayed the same, the P/E ratio would be 61.

Remember that earnings growth plays a role. At the time of writing, the earnings per share estimate for Apple for the following year is $4.01 per share. At a price of $125, the forward P/E would be 31. This is lower than the standard P/E because earnings are expected to rise.

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P/E ratio meaning in trading

The price-to-earnings ratio helps traders to assess how much they are paying for a stock. Traders don’t just look at the raw number; they also look at how the current ratio compares to historical ratios for the stock, how it compares to other companies in the same sector, the overall P/E of a stock market index​, and the earnings growth potential of the company.

For example, $1 of earnings on a $48 stock may seem expensive at a 48 P/E. But if earnings next year are expected to be $3, then forward P/E is 16. If investor expectations are that earnings could be $10 a few years down the road, paying $48 now may be a good deal. They are paying a 4.8 P/E based on future earnings, should those earnings materialise.

Companies with a high earnings growth rate tend to trade at higher P/E ratios than companies that aren’t growing. This is because people are willing to pay a higher price now if a company is expected to do well in the future. If this is indeed true for the future, the company stock price may be higher to reflect the company’s higher profits.

Companies with lower growth but stable earnings tend to have P/E ratios that fluctuate in a range. Earnings are more stable, so it is the fluctuations in share price over time that primarily cause P/E to fluctuate.

What is a good price-to-earnings ratio?

There isn’t a single “good” P/E ratio that guarantees a good purchase, as this will vary between companies, future expectations and overall trading goals. For example, a stock may have a P/E ratio of 1 but, if earnings are dropping every year, the share price could fall along with earnings year after year, all while maintaining the P/E of 1. This is called a “value trap”. The stock looks like a good deal because of the low price-earnings ratio but, as the company’s profits are falling, some wary investors may stay away.

Similarly, a high P/E of 50 may be good value if the company has a high growth rate. If earnings double in the following year, based on the current share price, this is only a 25 P/E ratio, which starts to look more attractive. Investors and institutional money managers are often projecting out multiple years to assess whether a stock is a good purchase now. This is a technique often practised by value investors.

For reference, going back to 1870, the average P/E ratio of major stock indexes have fluctuated between 5 and 25. Since the late 1990s, ratios have tended to be more elevated, typically staying above 15 and reaching over 60 in the stock market crash of 2008 and 2009. In the 2009 case, P/E ratios exploded higher, even though stock prices were dropping and many companies had even faster declines in earnings.

An additional tool that traders can use is price-earnings-to-growth, or the PEG ratio. This is calculated by dividing the P/E ratio by the growth rate of the stock in question. For example, if the P/E is 40 and earnings grew by 30% this year over last year, the PEG ratio would be calculated as: 40/30 = 1.3.

No matter how promising a stock looks, some traders consider using a risk-management strategy​ such as a stop-loss order on their charts. This helps to exit a trade at a specified level if the price goes against their position.

What does a negative P/E ratio mean?

While the price of a stock can’t go negative, earnings can if the company is losing money. If a stock is priced at $20 but loses $1 per share, it will have a negative P/E ratio of -20. While some financial news sources show negative P/E values, many just put “N/A” or not applicable, since P/E ratios are not especially useful for stocks with negative earnings. A large number of traders choose to avoid trading on shares with negative or non-existent price-earnings ratios, as this could place their trade at a higher risk.

How to use P/E ratios

To use P/E ratios when assessing your share trade, you will need to analyse the current share price and earnings amounts. This type of information is available on most financial news sites, as well as in a specific section on our advanced trading platform, Next Generation. After registering for an account, you will have access to our Morningstar equity research reports that provide information for a large number of shares and ETFs. Simply type a company name or ticker symbol into the Product Library window, right-click on it, then select Morningstar Research.

Morningstar’s fundamental analysis reports are available both on our desktop platform and through our mobile trading app. This way, you can make trading decisions quickly and on-the-go. Learn more about our Morningstar platform feature.

With price-earnings to your knowledge, you could consider whether current and future earnings justify the current stock price, bearing in mind that growth rates can change at any time. P/E ratios are an effective tool but successful investors tend to use a combination of fundamental and technical analysis when making an overall decision.

Price-to-earnings ratios: advantages and disadvantages

P/E ratios can be useful, and here is a summary of the advantages:

  • They are simple to calculate when doing company analysis.
  • The ratios factor in both earnings and cost (share price).
  • They can provide a quick assessment of whether a stock is over or undervalued.

However, P/E ratios also have drawbacks, including the following:

  • The ratio is quick to calculate but assessing whether a stock is under or overvalued requires more work than simply looking at the raw number.
  • They are not useful if the stock has negative earnings.
  • They do not consider growth prospects in the company, unlike forward P/E and PEG ratios.
  • Different stocks have different P/E ranges; some tend to always be high and others always low. Making an informed decision using P/E requires additional research.

Similar to other fundamental analysis tools, the P/E ratio it is not perfect when it comes to making investment decisions. If traders decide to use it as part of their stock research, they could develop a trading plan​ first for how it will be implemented. As part of the plan, this could include risk-management protocols, including having a stop-loss exit point and only dedicating a portion of available funds into any single trade to help control losses if the trade doesn’t move as expected.

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Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.

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