Using the Price-to-Earnings (P/E) Ratio and PEG Ratio to Assess a Stock (2024)

Theprice-to-earnings ratio(P/E)is one of the most widely used metrics for investors and analysts to determinestock valuation. It shows whether acompany’s stock price is overvalued or undervalued and can reveal how astock’s valuation compares with its industry group or a benchmark like the S&P 500 Index. A good P/E for one group or sector could be a poor P/E for another sector, so comparisons should compare similar companies.

The P/E ratio helps investors determinethe market value of a stock compared with the company’s earnings. It shows what the market is willing to pay for a stock based on its past or future earnings.

Key Takeaways

  • The P/E ratio is calculated by dividing the market value price per share by the company’s earnings per share (EPS).
  • A high P/E ratio can mean that a stock’s price is high relative to earnings and possibly overvalued.
  • A low P/E ratio might indicate that the current stock price is low relative to earnings.
  • An investor could look for stocks within an industrythat is expected to benefit from the economic cycle and find companies with the lowest P/Es to determine which stocks are the most undervalued.

What Is a P/E Ratio?

Companies that grow faster than average, such as technology companies, typically have higher P/Es. Ahigher P/E ratio showsthat investors are willing to pay a higher share price now due to growth expectations in the future.The median P/E for the S&P 500 was 15.00 as of June 2024.

Investors usethe P/E ratio to determine not only astock’s market valuebut also its futureearnings growth. If a company’s earnings are expected to rise, investors might expect the company toincrease its dividendsas a result. Higher earnings and rising dividendstypically leadto a higher stock price.

Formula and Calculation of the P/E Ratio

The P/E ratio is calculated by dividing the stock’s current price by its latest earnings per share: Current price / most recent earnings per share = P/E ratio.

Earnings per share (EPS) is the amount of a company’s profit allocated to each outstanding share of a company’scommonstock. It serves as an indicator of the company’s financial health. Earnings per share is the portion of a company’s net income that would be earned per share if all profits were paid out to its shareholders.EPS is typically used by analysts and traders to establish the financial strength of a company. EPS providesthe “E” or earnings portionof the P/E valuation ratio.

Analyzing P/E Ratios

A stock should be compared with other stocks in its sector or industry group to determine whetherit’s overvaluedorundervalued. Similar companies should be compared to each other, like insurance to insurance or oil producer to oil producer.

An industry group will benefit during a particular phase of thebusiness cycle in most cases, so many professional investors will concentrate on an industry group when their turn in the cycle is up. Remember that the P/E is a measure of expected earnings. Inflationtends to rise as economies mature. The Federal Reserveincreases interestrates as a result of slowing theeconomyandtaming inflation to prevent a rapid rise in prices.

Certain industries do well in this environment. Banks earn more income as interestrates rise because they can charge higher rates on their creditproducts, such as credit cards and mortgages. Basic materials and energy companies also receive a boost in earnings frominflation because they can charge higher prices for the commodities they harvest.

Interest rates will typicallybe low and banks tend to earn less revenue toward the end of an economic recession. But consumercyclical stocksoften havehigher earnings because consumers may be more willing to purchase on credit when rates arelow.

Limitations to the P/E Ratio

The first part of the P/E equation orpriceis straightforward because the current market price of a stock is easily obtained, but determining an appropriate earnings number can be more difficult. Investors must determinehow to define earnings and the factors that impact earnings. There are some limitations to the P/E ratio as a result as certain factors impact the P/E of a company.

Volatile Market Prices

Volatile market prices can throw off the P/E ratio, but this more commonly happens in the short term.

Earnings Makeup of a Company

The earnings makeup of a company is often difficult to determine. The P/E is typicallycalculated by measuring historical earnings or trailing earnings, but historical earningsaren’t of much use to investors because they reveal little about future earnings.

Investors are most interested indetermining future earnings.

Forward earnings orfuture earningsare based on the opinions ofWall Streetanalysts, and they can be overly optimistic in their assumptions during periods of economic expansion. They can be overly pessimistic during times ofeconomic contraction.

One-time adjustments such as thesale of a subsidiarycould inflateearnings in the short term. This complicates the predictions of future earnings because the influx of cash from the salewouldn’t be a sustainable contributor to earnings in the longterm.Forward earnings can be useful, but they’re prone to inaccuracies.

Earnings Growth

Earnings growth isn’t included in the P/E ratio.The biggest limitation of the P/E ratio is that ittells investors littleabout the company’s EPS growth prospects. An investor mightbe comfortable buying in ata high P/E ratio, expecting earningsgrowth tobring the P/E back down to a lower level if the company is growing quickly. But they might look elsewherefor a stock with a lower P/E if earnings aren’t growing quickly enough.

It can be difficult to tell if a high P/E multiple is the result of expected growth or if the stock is simply overvalued.

PEG Ratio

A P/E ratio doesn’t always show whether the P/E is appropriate fora company’s forecasted growth rate even when it’s calculated using a forwardearnings estimate. Investorsturn to another ratio known as the price/earnings-to-growth (PEG) ratio to address this limitation.

The PEG ratio measures the relationship between the price/earnings ratio and earnings growthto provide investors with a more complete story than the P/E alone.

The PEG ratio allows investorsto calculate whether a stock’s priceisovervalued or undervaluedby analyzing bothtoday’s earnings and the expectedgrowth rate for the company in the future.

Example of a PEG Ratio

An advantage of using the PEG ratio is that you can compare the relativevaluationsof different industries that may have very different prevailing P/E ratios. This facilitates the comparison of different industries that each tends to have its own historical P/E range.

Here’s a comparison of the relative valuation of a biotech stock and an integrated oil company.

Biotech Stock ABCOil Stock XYZ
Current P/E35 times earnings16 times earnings
Five-year projected growth rate25%15%
PEG35/25, or 1.4016/15, or 1.07

These two fictional companies have very different valuations and growth rates, but the PEG ratio gives an apples-to-apples comparison of the relative valuations. The PEG ratio of the S&P 500 would be 16 / 12 = 1.33 if the S&P 500 had a current P/E ratio of 16 times trailing earnings and if the average analyst estimate for future earnings growth in the S&P 500 is 12% over the next five years.

What Does It Mean When a Company Has a High P/E Ratio?

A company with a current P/E ratio of 25, which is above the S&Paverage, trades at 25 times its earnings. The high multiple indicatesthat investors expect higher growth from the company compared with the overallmarket. A high P/E does not necessarily mean astock is overvalued. AnyP/E ratio should be considered against the backdrop of the P/E for the company’sindustry.

What Is a Sector?

A sector isa general segment of the economy that contains similar industries. Sectors are made up of industry groups, and industry groups are made up of stocks with similar businesses such as banking or financial services.

What Is a Relative Valuation?

A relative valuation is a mathematical way of determining whether a specific stock or a broad industry is more or less expensive than a broadmarket index such as theor theNasdaq.

The Bottom Line

The price-to-earnings (P/E) ratio is one of the most common ratios that investors use to determine if a company’s stock price is properly valued relative to its earnings. The P/E ratio is popular and easy to calculate, but it has shortcomings that investors should consider when using it to determine a stock’s valuation.

The P/E ratio doesn’t factor in future earnings growth, so the PEG ratio provides more insight intoa stock’s valuation. The PEG is a valuable tool for investors incalculatinga stock’s future prospects because it provides a forward-looking perspective. However, no single ratio can tell investors all they need to know about a stock. It’s important to use a variety of ratios to arrive ata complete picture of a company’s financial healthand stock valuation.

Every investor wants an edge in predicting a company’s future, but a company’s earnings guidance statements may not be a reliable source.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.

  1. multpl. “S&P 500 PE Ratio.”

  2. EDUCBA. “Price to Earning Ratio Formula.”

  3. University of Minnesota Libraries, Publishing Services. “16.5 The Computation of Earnings per Share.”

  4. Corporate Finance Institute. “PEG Ratio.”

  5. Cambridge Dictionary. “Sector.”

Using the Price-to-Earnings (P/E) Ratio and PEG Ratio to Assess a Stock (2024)

FAQs

Using the Price-to-Earnings (P/E) Ratio and PEG Ratio to Assess a Stock? ›

Price/earnings-to-growth ratio

What is a good PEG ratio for a stock? ›

What Is a Good PEG Ratio? As a general rule, a PEG ratio of 1.0 or lower suggests a stock is fairly priced or even undervalued. A PEG ratio above 1.0 suggests a stock is overvalued.

How do you calculate the fair value of a stock using PE ratio? ›

The P/E for a stock is computed by dividing the price of a stock (the "P") by the company's annual earnings per share (the "E").

How do you compare stocks with PE ratio? ›

You can use a P/E ratio to compare a company's cost to that of the broader market or against its peers in the same sector. If, for example, you had one company trading with a P/E ratio of 10 and another with a P/E of 20, you'd say that the lower P/E indicated a cheaper stock.

What should be the good PE ratio to buy a stock? ›

As far as Nifty is concerned, it has traded in a PE range of 10 to 30 historically. Average PE of Nifty in the last 20 years was around 20.* So PEs below 20 may provide good investment opportunities; lower the PE below 20, more attractive the investment potential.

Which is better PE or PEG ratio? ›

The price/earnings-to-growth, or PEG, ratio tells a more complete story than P/E alone because it takes growth into account. Investors are often willing to pay a higher premium for greater earnings growth, whether it's from past growth or estimated future growth. The lower the PEG ratio, the more undervalued the stock.

What is a bad PEG ratio? ›

PEG ratios greater than 1.0 are generally considered unfavorable, suggesting a stock is overvalued. Meanwhile, PEG ratios lower than 1.0 are considered better, indicating a stock is relatively undervalued.

What is the PEG ratio for dummies? ›

The price/earnings-to-growth ratio, or PEG ratio, divides a company's price-to-earnings (P/E) ratio by its earnings growth rate over a specific period. It strengthens the P/E ratio by taking into consideration the growth rate of earnings.

What is considered a high P/E ratio? ›

Typically, the average P/E ratio is around 20 to 25. Anything below that would be considered a good price-to-earnings ratio, whereas anything above that would be a worse P/E ratio. But it doesn't stop there, as different industries can have different average P/E ratios.

What does a PE ratio tell you? ›

That is, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E ratio could signal that a stock's price is high relative to earnings and is overvalued.

Is PE ratio a good indicator? ›

Price Earnings (P/E) ratio is one of the most popular ways of valuing a stock. The thumb rule is that a low P/E ratio is a sign of undervaluation while a high P/E ratio is a sign of overvaluation. But such an approach of purely using P/E Ratio to Value a stock is fraught with risks.

Is it better for PE ratio to be higher or lower? ›

P/E ratio, or price-to-earnings ratio, is a quick way to see if a stock is undervalued or overvalued. And so generally speaking, the lower the P/E ratio is, the better it is for both the business and potential investors. The metric is the stock price of a company divided by its earnings per share.

Which is the most bullish scenario for a company's stock price? ›

Which is the most bullish scenario for a company's stock price? When its expected earnings are higher than expected and its P/E ratio increases.

What does PE ratio say about a stock? ›

Price to earnings ratio, or P/E, is a way to value a company by comparing the price of a stock to its earnings. The P/E equals the price of a share of stock, divided by the company's earnings-per-share. It tells you how much you are paying for each dollar of earnings.

How to estimate a stock price? ›

Price-to-earnings ratio (P/E): Calculated by dividing the current price of a stock by its EPS, the P/E ratio is a commonly quoted measure of stock value. In a nutshell, P/E tells you how much investors are paying for a dollar of a company's earnings.

How to use PE multiple in valuation? ›

P/E is one of the most commonly used valuation metrics, where the numerator is the price of the stock and the denominator is EPS. Note that the P/E multiple equals the ratio of equity value to net Income, in which the numerator and denominator are both are divided by the number of fully diluted shares.

How to calculate target price using PE ratio? ›

Price targets are typically calculated by dividing your current PE ratio by your forward PE ratio, and then multiplying the resulting figure by your current stock price.

References

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