What Is the P/E Ratio? Formula, Examples and Limits

The formula

P/E = share price ÷ earnings per share (EPS). If a share costs $100 and the company earned $5 per share in the last twelve months, the P/E is 20. Equivalently, P/E = market capitalisation ÷ net income.

The inverse, EPS ÷ price, is the earnings yield. A P/E of 20 corresponds to an earnings yield of 5%. That makes it easy to compare with the interest on a bond: at a P/E of 20 you "buy" 5 cents of annual profit for each dollar invested.

Trailing versus forward P/E

• Trailing P/E uses the profit already reported over the last twelve months. It is factual but looks backwards.
• Forward P/E uses analysts' expected earnings for the next twelve months or fiscal year. It looks ahead but depends on forecasts that are often revised.
• Fast-growing companies usually have a forward P/E much lower than the trailing one. If the two are far apart, find out why before comparing.

Live examples

The table shows the P/E of the largest companies in the S&P 500 next to the median P/E of the companies in the same sector that ATLAS tracks inside the index. Compare each company with its own sector, not with the whole market.

What a high or low P/E means

• High P/E: investors expect strong growth, or the company is seen as safe and high quality, or earnings are temporarily depressed.
• Low P/E: the company may be undervalued, or the market expects earnings to fall, or the profits are at a cyclical peak.
• No P/E at all: the company lost money in the last twelve months. The ratio cannot be calculated.

When the P/E misleads

• Cyclical industries. A low P/E at the top of the cycle is often a warning.
• One-off items. Selling a business or writing off an asset moves net income and the ratio with it.
• Different accounting. Banks, insurers and real-estate companies are better judged with other ratios such as price-to-book.
• Debt. Two companies with the same P/E can carry very different debt. Compare net debt to earnings.

P/E versus fair value

The P/E is a comparison tool: it needs peers or history to mean anything. Fair value adds a view of the future cash flow of the company itself. They answer different questions, so ATLAS shows both on every company page and uses sector multiples as one of the two inputs to its fair value.

Continue with how to know if a stock is cheap for a full routine.