What Is a P/E Ratio?
P/E means price to earnings. It shows how many years of profit you pay for when you buy a share. A P/E of 20 means the price is 20 times the profit the company makes each year.
What P/E ratio means
Imagine a small shop makes $100 profit a year. Someone sells it to you for $2,000. You are paying 20 years of profit. That is a P/E of 20.
A share works the same way. The company's profit is split across all its shares. The P/E ratio compares what one share costs with the profit that one share earned. That second number is called earnings per share, or EPS.
How to calculate it
Say a company's share costs $150. Over the last year it earned $5 of profit for each share. Then $150 ÷ $5 = a P/E of 30.
You pay 10 years of profit. Cheap, or investors expect trouble.
You pay 40 years of profit. Pricey, or investors expect fast growth.
Is a high P/E ratio good?
Not by itself. People pay a high P/E when they believe profit will grow a lot. If it does, today's high price may turn out fair. If it does not, the price often falls hard.
So is a P/E of 30 or 40 good? It depends on growth. A company that doubles its profit every few years can deserve 40. A slow company at 40 is probably too expensive. The PEG ratio puts P/E and growth into one number.
What does a low P/E mean?
A low P/E can mean a bargain. But it often means the market thinks profit will shrink. Check why the number is low before you call it cheap.
What does a negative P/E ratio mean?
A negative P/E means the company lost money over the last year. There is no profit to divide by, so the number turns negative. Most websites show "N/A" or a dash instead.
It does not tell you how cheap or expensive the stock is. Many young companies lose money while they grow. For them, look at revenue growth and how much cash they have left. The price-to-sales ratio works even when there is no profit.
What is a good P/E ratio?
There is no single good number. A fair P/E for a bank is often much lower than for a software company. The best test is to compare a company with others in its own industry and with its own past P/E. You can also compare it with the S&P 500 as a whole.
Common mistakes
- Comparing different industries. A software company and a bank have very different normal P/E levels. Compare a company with its own kind.
- Trusting a low number. A cheap-looking P/E can be a trap if profit is about to drop.
- One-off profits. A big one-time gain, like selling a building, can make the P/E look lower than the real business deserves.
Trailing vs forward P/E
Trailing P/E uses profit from the last 12 months. It is real, but it looks backward. Forward P/E uses profit analysts expect next year. It looks ahead, but it is only a guess.
See it in real companies
Open a company to see what it sells and how it makes money.