Key concepts
The price-to-earnings ratio reflects the amount that investors are willing to pay for every dollar earned by the company, making it a quick way to assess whether the asset is overvalued or undervalued.
There are several types of price-to-earnings ratios — such as trailing, forward, absolute, and relative ratios — that provide diverse perspectives, but all require context such as industry standards and the company's growth potential.
The price-to-earnings ratio does not work well for cryptocurrencies since most do not generate profits and do not report in the same way companies do. However, similar valuation methods are being tested in some areas of decentralized finance.
Introduction
If you've ever considered buying stocks, you've likely come across the term price-to-earnings ratio (P/E), which is one of the most common tools used by investors to determine whether stocks are worth buying. But what does this term actually mean, and how can you use it?
What is the price-to-earnings ratio?
The price-to-earnings ratio compares a company's share price to the amount of earnings the company generates. This ratio helps investors determine whether a stock is overvalued, undervalued, or fairly valued by comparing the company's current share price to its earnings per share.
In other words, it shows the amount that investors are willing to pay for every dollar of the company's earnings.
Price-to-earnings ratio equation
Price-to-earnings ratio = (Share price / Earnings per share)
We can calculate earnings per share by dividing the company's total earnings (after taxes and preferred dividends) by the weighted average number of common shares that can be purchased by people over a certain period.
Types of price-to-earnings ratios
There are more than one way to look at the price-to-earnings ratio, each giving you a slightly different perspective:
Trailing price-to-earnings ratio: Based on the company's earnings over the past twelve months, these are the most commonly used figures in reports and reflect actual performance.
Price-to-earnings ratio (P/E): Uses expected earnings for the next twelve months, based on analysts' estimates and forecasts.
Absolute price-to-earnings ratio: This is simply the calculation of the price-to-earnings ratio based on the basic earnings — that is, the current price divided by the most recent earnings per share — without comparing it to anything else.
Relative price-to-earnings ratio: Compares a company's price-to-earnings ratio to a benchmark, such as industry average or historical performance.
Interpreting the price-to-earnings ratio
Understanding what the price-to-earnings ratio means requires context. A high price-to-earnings ratio may indicate that investors expect significant earnings growth in the future and are willing to pay a price for those expected earnings. Conversely, a low price-to-earnings ratio might suggest that the stock is undervalued or that the company is facing some challenges.
However, a "high" or "low" price-to-earnings ratio varies by sector or industry. For example, technology companies often have a higher price-to-earnings ratio compared to utility companies due to growth potential.
Reasons for the importance of the price-to-earnings ratio
The price-to-earnings ratio is a quick way for investors to gauge stock valuation. This ratio is especially useful when comparing companies in the same sector. For example, if two companies are in the same sector but one has a much higher price-to-earnings ratio, investors may seek to verify whether that price is justified by stronger growth expectations or other factors.
The price-to-earnings ratio also plays a role in:
Screening: Investors may use the price-to-earnings ratio to filter stocks that may be undervalued.
Evaluating past trends: Comparing a company's current price-to-earnings ratio with its past can indicate how market perceptions have changed over time for that company.
Benchmarking: Comparing a price-to-earnings ratio to industry averages or broader market benchmarks can help provide context for whether stocks are priced reasonably or not.
Shortcomings of the price-to-earnings ratio
Although the price-to-earnings ratio is a useful measure, it is not perfect and should not be used in isolation, and there are some shortcomings to keep in mind:
Not useful if earnings are negative: If the company is losing money, the price-to-earnings ratio doesn't really apply.
Does not reflect growth differences: A high price-to-earnings ratio may be acceptable for a company with a high growth rate, while a low ratio may be suitable for a mature company with stable earnings; context is essential.
It can be manipulated: Companies can sometimes alter the way they report earnings to make things look better than they are.
Ignores other factors: The price-to-earnings ratio does not take into account debt levels, cash flow, or other fundamental factors.
So, while it's useful, you should always look at other numbers as well, such as revenue, profit margins, and the amount of debt the company carries.
Comparing price-to-earnings ratios across different industries
Price-to-earnings ratios can vary significantly depending on the type of company, making it essential to compare companies within the same industry. For example:
Technology sector: This sector often has a higher price-to-earnings ratio due to expectations of rapid growth.
Utility sector: Typically, the price-to-earnings ratio in this sector is low because it generates stable and predictable earnings.
If you compare a technology company with a utility company by only looking at the price-to-earnings ratio, you might get a misleading idea.
Price-to-earnings ratios and cryptocurrencies
You might wonder if the price-to-earnings ratio is useful with Bitcoin or other cryptocurrencies; the short answer is no. The price-to-earnings ratio is designed for companies that report clear earnings because you need earnings numbers to calculate the ratio. Most cryptocurrencies do not report earnings in the same way companies do.
However, in some areas of cryptocurrency — such as decentralized finance platforms that earn profits from fees — analysts sometimes use similar ideas. For example, they might assess the price of cryptocurrencies relative to the amount of profits the platform earns from fees. But these ideas are still experimental and not widely used, yet they show how people are trying to introduce familiar financial concepts into the world of cryptocurrencies.
Closing thoughts
The price-to-earnings ratio is a widely used metric that provides insights and ideas on stock valuation by comparing its current price to its earnings. It helps investors understand whether the stock price is fair based on its earnings potential. While the price-to-earnings ratio is not a perfect measure — and should not be used in isolation — it is a strong starting point for those looking to evaluate stocks.