P/E Ratio Explained

Wouldn’t it be nice if you had a little voice telling you when you should invest?

Say hello to the P/E ratio! While this isn’t quite the little voice you’d prefer, it is a good indicator as to when you should invest in a company.

The P/E ratio is found using a calculation that takes a company’s share price and earnings per share into account. The result is a number that can give you a good idea of the value of a company’s shares–allowing you more insight into an investment before you put your hard-earned money on the line. 🚀

Although the P/E ratio can be a useful tool, there are other things you must take into consideration when using it to consider stocks. This is because it isn’t always as simple as it seems. And sometimes, even analysts, like those who were comparing the P/E ratio of different car companies, can be confused by what they see. 

So if you want to learn to use P/E ratios to properly guide your future investments, keep reading. This way, you will know exactly what you are investing in when you choose to put money in a company based on its P/E ratio. 

What is a P/E Ratio? 📚

P/E ratio stands for price to earnings ratio and it is one of many metrics that can be used to judge whether an investment in a certain company is desirable. It is calculated by dividing the market price per share by the earnings per share. This will give you a general idea of how the stock of the company is valued. 

One way to think of P/E is that it is the number of dollars you would have to invest in a company in order to earn one dollar. For example, if Apple has a P/E of 240, this means that you would have to invest $240 today in order to earn $1 of earnings off of your share of Apple in the future. If you think this sounds a bit expensive, this is because it is. 

Generally, you want to invest in a company that has a lower P/E. This is because a high P/E, like that of Apple above, is usually associated with a stock that is overvalued. While it may seem weird to look at investing in a company this way, where the P/E ratio really comes into play is when you compare two similar companies. 

This is because if you are trying to decide between two companies in the same industry, it is best to go with the one that is less overvalued. So, if you were trying to decide between an investment in Apple or Microsoft, this is a time when you would want to look at the P/E ratio. 

The logic behind the P/E ratio is that you are looking for the best “deal” for your money so to speak—you are looking at the P/E ratio to find out which stock is a better buy. 

P/E Ratio Formula 💰

The cool thing about the P/E ratio is that it isn’t hard to calculate. This means that if you ever can’t find the metric readily available for a stock you are interested in, it will only take a moment to figure out. 

Here is the equation you can use to calculate the P/E ratio:

Basically, you can find the ratio by looking up the current stock price for the asset you are interested in, then divide it by the earnings per share in the most recent earnings statement. 

Absolute and Relative P/E Ratio 🏛️

This number that we calculated above is known as the absolute P/E, and as mentioned, it is representative of how much investors are willing to pay for one dollar of a particular stock. You can use a couple different measures of EPS (Earnings per share) to calculate this, such as trailing EPS or estimated EPS.

The relative P/E ratio is something a little different. This metric compares the current P/E ratio of a company, to past P/E ratios that have been calculated for that same company. Sometimes, it is the current P/E ratio compared to a benchmark P/E ratio. This metric is used to see what percentage of the past P/E’s calculated a stock has reached. 

For example, sometimes a company may just have a bad year. Look at 2020 and how many companies had a rough time because of COVID19. This means that you may not want to go off of the P/E ratio of last year. Instead, you would want to look at a past P/E ratio that has been calculated by the company. This will also give you an idea as to how many times the company has made what it was calculated to make.

Let’s look at Six Flag (SIX) which had a rough year in 2020 because of COVID19. The P/E ratio in 2020 was -8.93, which happened because the company lost money due to being closed for half the year. But if you look at 2019, their P/E ratio was 21.25, and in 2018 it was 15.98, both numbers which make it seem like a very investable company. 

This is why, on this occasion, before considering an investment in SIX, you would want to take the relative P/E ratio, to find out what sort of P/E the company is likely to have in the coming year without using the EPS data gathered from the previous outlier year. 

What is a Good P/E Ratio ⚖️

Before you try your hand at becoming the next Wolf of Wall Street, it’s important to know what is considered a good P/E ratio when it comes to choosing stocks. 

Historically, a P/E closer to the number 1 or 2 is considered a “good” P/E. And any P/E below 1 is considered excellent. But before you start looking for the elusive company with an excellent or good P/E  you should know that P/E doesn’t necessarily work as well as it used to when it comes to judging whether or not you should invest in a company.

The P/E ratio, as previously mentioned, is best used when comparing two companies in the same sector to one another. This is because the P/E ratio can give you a good idea of the maximum amount of money you should be willing to spend on a certain asset in an industry.

Also, you need to keep in mind that you should never judge a stock based on just one aspect of its performance. The P/E ratio is but one metric to measure a stock’s health, and it is not absolute, or always the best information on a company.  

Tesla 🎯

For example, if you take a look at Tesla (TSLA) you can see it had a P/E ratio of 1599 for the year 2020. Remember, this means that investors were willing to pay almost $1600 for every one dollar a share of TSLA stock is currently earning or will earn in the future. This indicates that Tesla is an extremely overvalued company, and if you judged on this fact alone, you probably would avoid purchasing stock in Tesla. 

But, when you take a look at the chart of Tesla’s growth, you’ll notice that one TSLA share purchased at $83 in December 2019 is now worth over $1000. This means that Tesla was a good investment even if the P/E doesn’t show it because the company showed impressive growth in a very short period of time. 

General Motors 📉

Meanwhile, on the other hand, if you have a company like General Motors (GM) which had a P/E ratio of 11.96 in 2020, you might think that this would be a good investment to add to your portfolio. But if you look at the chart, you will see that GM hasn’t had near the amount of growth as Tesla has had during the same period. 

So even though General Motors have the “better” P/E, it was not the better investment, meaning that the P/E ratio wasn’t the best judge of company health when comparing these two companies, even though they are in the same(-ish) sector. 

The 3 Types of P/E Ratio 👇

Like anything else in life, when it comes to the P/E ratio, it’s good to have a little variety. 

This is why, before you start scouring the charts, you need to be aware that there are three different types of P/E ratios. 

TTM Earnings 💸

The first type of P/E ratio is TTM or trailing twelve months P/E ratio. This ratio is calculated using the EPS of the company in the past 12 months. This is probably the most popular P/E ratio you will come across when researching stocks using a premium brokerage platform.

Forward Earnings 💵

This P/E ratio is exactly what it sounds like, it is calculated using the earnings a company is expected to earn in the future. This metric, while speculative, can help you know what to expect from a specific asset in the coming year. This number is a bit harder to find, you’ll probably have to use sources of info outside of your brokerage platform. 

Shiller P/E Ratio 💳

The third P/E ratio is called the Shiller P/E ratio and it is used to find the average earnings of a company over a period of time. This P/E ratio is a bit unique because it divides price by the average earnings of a company over the past ten years. It also takes inflation into account. 

Say you wanted to find the Shiller P/E ratio of a company, like Disney. First, you would find the current stock price then you would need to take an average of the company’s earnings for the past ten years. The problem is, the U.S. has an inflation rate that has been rising in the past few years, and you have to take this into account too. 

And for those who wanted to be really precise, you would need to adjust for inflation using the rate for each particular year. Once you have adjusted the earnings each year for inflation, you could add them together and divide them by 10 to get the denominator for your P/E ratio. 

If this sounds complicated, it’s because it is. Don’t worry though, if you truly want to use the Shiller P/E ratio, many broker websites have a calculator built into their website to allow investors to plug in their data and reach an answer. 

Despite being more difficult to calculate, because the Shiller P/E takes inflation into account, it is generally considered more accurate than the regular P/E ratio. This is why the Shiller P/E ratio is often used to measure the value of the S&P 500 Index. 

How to Find Stock P/E Ratios 🔎

Now, if you think that you could benefit from looking at the P/E ratios of companies before you invest in them, it’s important to know where you can find this information. 

Of course, the most obvious solution is to spend time reading the financials on your stock of choice, finding the EPS for the period of time you wish to use, then dividing the current stock price by this number. If you think this sounds time-consuming, you aren’t wrong. 

This is why you should probably find a good investment app that will find this information for you. Most brokerage platforms will provide you with this information with a click of a button, saving you lots of hours of research (and the hassle of finding a calculator 🧮). 

What is the Average P/E Ratio for S&P 500 Stocks? 👨‍🏫

For those that haven’t noticed, the P/E ratio of a company can clearly be all over the place. So how can you expect to know what a good P/E ratio is?

Well, P/E ratios have increased over the years meaning that it is unrealistic to look for that P/E ratio of just one entity. Instead, most investors gauge whether a P/E ratio is good or not by comparing it to the P/E ratio of the S&P 500. 

This is because the P/E ratio of the S&P 500 gives you a good look at the health of the market as a whole. Thus, if the S&P 500 has a P/E ratio of 30, you could assume that any stock with a P/E ratio of 30 or lower is a reasonable investment. 

To get an idea of how P/E ratios have changed over the years, take a look at the chart below. It features the S&P 500 P/E ratio in the years following 1910. 

As you can see, what is considered acceptable for a P/E ratio has changed considerably over the years. While 16 was a great milestone for a P/E ratio in 1970, in the modern-day you would be hard-pressed to find a P/E ratio that low. Instead, you can look for one closer to 20 and still be OK. 

Just to give you an idea of how much this benchmark can change, the P/E ratio for the S&P 500 was 35.96 on January 1st, 2021. Which is much higher than any of the other averages for the ten-year ranges in the chart. Thus, in the year 2021, a company with a P/E ratio of around 30 would be considered a good buy. 

The Risks of Trusting P/E Ratios ⚠️

Like anything in the stock investment realm, trusting P/E ratios is risky, and this is because they aren’t always a good indicator of how a company will perform in the future. 

Remember the example of General Motors and Tesla from above? Clearly, if you had made your investment decision based on the P/E ratio, you would have been disappointed that you had chosen GM over the lucrative TSLA. This is just one example of a risk involved in trusting P/E ratios–and that is that they aren’t always predictive of a growth the company will experience.

Not to mention that new companies with little to no income pose a huge problem. Remember that when you divide any number by 0, the answer is 0. Therefore, even if there is an awesome new company with a product you think will take the world by storm, you will likely not invest if you are relying on just the P/E ratio, because it will likely be high. 

And this brings up the third issue with trusting the P/E ratio, and this is that when a company is having difficulties, there are several aspects that could make the P/E ratio look better than the health of the company. 

For example, a company could have a decline in stock price over the past 6 months, preparing to go under, but if you use the EPS from the previous year in the calculation, you would see an improving P/E ratio and probably consider an investment even though the company is about to close. 

This is why it is so important to research a company before you buy its stock, even when using the P/E ratio to try and gauge the health of a company or compare two companies in the same sector. 

How to Use the P/E Ratio Properly 🏗️

Hopefully, the previous section didn’t make you want to throw in the towel on P/E ratios just yet, as there are several helpful ways to use this metric when you are looking to invest. 

The best way to use a P/E ratio is to compare two companies in the same industry, while also comparing to the average P/E ratio of an industry to find out if a stock is a growth or value stock (or just a bad one). This can help guide your decision when it comes to deciding between a few different assets. It can also give you an idea of future returns. 

You can see this when you look at Disney (DIS) and Six Flags (SIX) P/E ratios. Both companies are in the entertainment industry with theme parks all over the world. In 2020, DIS had a P/E ratio of 86, while SIX had a P/E ratio of -8.63. 

Now, if you look at the P/E ratio alone, you would definitely place an investment in SIX. But hopefully, you know a little something about these companies, and you know that Disney is a little bit better of a buy because they have had more stable prices over the past couple of years and higher returns. You should note, however, that both companies have experienced growth to some extent. 

What you can deduce from this information, when comparing it to the S&P 500 P/E ratio of 35.96, is that Disney is a growth company, while Six Flags is a value company in the same sector. So if you are looking for an investment in a theme park, and want one that will grow, choose Disney (just know it will be a more expensive investment), and if you are looking for an investment that is the best value for your money in theme parks, buy Six Flags. 

Just don’t forget to take current events into account along with your study of the P/E ratios. This is especially true when it comes to companies such as Disney and Six Flags because both were affected by the COVID19 pandemic in 2020. 

Other Metrics Similar to the P/E Ratio 📗

If you haven’t noticed by now, it is almost impossible to use just the P/E ratio to make an investment decision. Below are a couple of other metrics you can use to evaluate stocks and should take into account when making your investment decisions. 

PEG 📈

Wish there was a way to see the P/E ratio with a company’s expected future growth taken into account? Well, this is exactly what you get when you look at the PEG, or price to earnings growth ratio of an asset. 

PEG is calculated by dividing the P/E ratio of a stock by its anticipated growth rate. It is generally considered to be more accurate when evaluating a company than the P/E ratio alone. But you also have to be very cautious, as the future anticipated growth of a company is speculative, and may not actually occur. 

This brings us back to Six Flags(SIX) which has been referenced multiple times in this article. Based on their P/E ratio of 2020 alone, no one would ever consider investing in them. But they had a hard year, and are now poised to grow quite a bit. 

Therefore those interested in investing in them would be better off looking at the PEG ratio which is currently 0.73, indicating that SIX is indeed a good investment for those wanting to add growth stocks to their portfolio. 

Earnings Yield 📊

Earnings yield is the opposite of the P/E ratio, literally. To calculate earnings yield, you will reverse the equation you used to find the P/E ratio, dividing the company’s EPS by the current stock price. 

This will give you an answer that is expressed as a percentage and it is used to tell an investor the rate of return of a particular investment. While not as widely used as the P/E ratio, it can be useful when it comes to predicting the short-term performance of an asset or comparing the value of investing in a certain asset when compared to the yield of the purchase of a bond in the current market. 

Say that you were interested in adding a low-risk investment to your portfolio, like Vanguard’s 500 S&P ETF(VOO). Before you add it, you want to be sure it will make more than the current bond yield rate. This is when you would use the earnings yield ratio. 

You’ll find that its expected yield is 1.73%. The current bond yield rate is 1.55% for a 10-year government bond. So in this instance, you would likely choose to add VOO to your portfolio over a bond. 

Conclusion 🏁

All in all, maybe the P/E ratio isn’t quite the little voice you want whispering in your ear as you choose your investments. But regardless of its downfalls, it can be a useful metric when it comes to evaluating the investment potential of a company. 

Therefore, the next time you find yourself torn between purchasing two different assets in the same asset sector, it may be worthwhile to pull out the P/E ratios to compare. Just don’t forget to pull out the S&P 500’s P/E ratio and some news stories about the company as well. 

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