# Practical Example

Key Takeaways

The P/E ratio shows how much investors are willing to pay for each dollar a company earns, making it a quick way to evaluate whether an asset may be overvalued or undervalued.

There are different types of P/E ratios—like trailing, forward, absolute, and relative—which offer various perspectives, but all require context such as industry norms and company growth potential.

The P/E ratio doesn’t work well for cryptocurrencies because most don’t generate earnings and reports in the same way companies do. However, there are similar valuation methods being tested in some areas of decentralized finance (DeFi).

Introduction

If you’ve ever looked into buying stocks, chances are you’ve come across the term P/E ratio. It’s short for the Price-to-Earnings ratio and is one of the most common tools investors use to figure out if a stock might be worth buying. But what does it actually mean, and how do you use it?

What Is the P/E Ratio?

The P/E ratio compares a company’s stock price to how much money the company earns. It helps investors determine whether a stock is overvalued, undervalued, or fairly priced by comparing the company's current share price to its earnings per share (EPS). 

In other words, it shows how much investors are willing to pay for each dollar of a company’s earnings.

P/E formula

P/E Ratio = (Share Price / Earnings Per Share)

We can calculate the Earnings Per Share (EPS) by taking the company’s total profit (after taxes and preferred dividends) and dividing it by the weighted average number of common shares that people can buy during a specific period.

Types of P/E Ratios

There’s more than one way to look at the P/E ratio. Each version gives you a slightly different view:

Trailing P/E: Based on the company’s earnings over the past 12 months. This is the most commonly reported figure and reflects actual performance.

Forward P/E: Uses predicted earnings for the upcoming 12 months. It’s based on what analysts estimate and expectations.

Absolute P/E: This is just the basic P/E calculation—current price divided by the latest EPS—without comparing it to anything else.

Relative P/E: Compares a company's P/E ratio to a benchmark, such as its industry average or historical performance.

Interpreting the P/E Ratio

Understanding what a P/E ratio means requires context. A high P/E ratio might suggest that investors expect high earnings growth in the future and are willing to pay a premium for those expected profits. On the other hand, a low P/E ratio might indicate that the stock is undervalued or that the company is facing challenges.

However, a "high" or "low" P/E ratio can differ depending on the sector or industry. For example, tech companies often have higher P/E ratios compared to utility companies due to their growth potential.

Why the P/E Ratio Matters

The P/E ratio is a quick way for investors to gauge a stock's valuation. It's especially useful for comparing companies within the same industry. For instance, if two companies are in the same sector but one has a much higher P/E ratio, investors may investigate whether the premium is justified by stronger growth expectations or other factors.

The P/E ratio also plays a role in:

Screening: Investors may use the P/E ratio to filter stocks that are potentially undervalued.

Evaluating historical trends: Comparing a company’s current P/E ratio with its past can indicate how the market’s view has changed over time in relation to that company.

Benchmarking: Comparing the P/E ratio to industry averages or the broader market can help provide context for whether a stock is reasonably priced.

Limitations of the P/E Ratio

As useful as the P/E ratio is, it’s not perfect and should not be used in isolation. There are a few limitations to keep in mind:

It doesn’t work if earnings are negative. If a company is losing money, the P/E ratio doesn’t really apply.

It doesn’t show growth differences. A higher P/E might be acceptable for a high-growth company, whereas a lower one might be suitable for a mature company with steady earnings. Context matters.

It can be manipulated. Companies can sometimes change the way they report earnings to make things look better than they are.

It ignores other factors. The P/E ratio does not consider debt levels, cash flow, or other fundamental factors.

So, while it’s useful, you should always look at other numbers as well, like revenue, profit margins, and how much debt the company has.

Comparing P/E Ratios Across Industries

P/E ratios can vary a lot depending on what kind of company you’re looking at. That’s why it’s important to compare businesses within the same industry. For instance:

Technology sector: These often have higher P/E ratios because they’re expected to grow quickly.

Utilities sector: These usually have lower P/E ratios because they have steady, predictable earnings.

If you compare a tech company to a utility company just by looking at their P/E ratios, you might get the wrong idea.

P/E Ratios and Cryptocurrency

You might wonder if the P/E ratio works for things like Bitcoin or other cryptocurrencies. The short answer is: not really. P/E ratios are meant for companies that produce clear profit reports because you need earnings to calculate the ratio. Most cryptocurrencies don’t produce earnings reports in the way businesses do. 

However, in some areas of crypto—like decentralized finance (DeFi) platforms that earn fees—analysts sometimes use similar ideas. For instance, they could evaluate the cryptocurrency price in relation to how much the platform earns from fees. These are still experimental and not widely used yet, but they show how people are trying to bring familiar finance concepts into the crypto world.

Closing Thoughts

The Price-to-Earnings (P/E) ratio is a widely used metric that offers insight into a stock’s valuation by comparing its current price to its earnings. It helps investors understand whether a stock is priced fairly based on its earnings potential. While the P/E ratio is not perfect—and shouldn’t be used alone—it’s a great starting point for those who want to evaluate stocks.

Further Reading

What Is a Yield Curve and How to Use It? 

What Is Basis Trading and How Does It Work?

What Is Technical Analysis?

How to Read the Most Popular Candlestick Patterns

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