P/E Ratios Help Advanced Investors Accurately Value Their Stocks, But You Probably Don’t Need to Worry About Them. Here’s What to Look for Instead

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When you invest in individual stocks, you’re bound to come across various metrics while researching potential purchases. Among them, you’ll see P/E, or price-earnings ratio. 

So what is it, and what can it tell you about the stock you’re considering? 

That largely depends on which of the 11 sectors the company’s in, and what data you choose for your calculations. The price-earnings ratio is a way to compare companies within the same sector or industry to see which is trading at a premium or discount in relation to its peers. “It’s the multiple of earnings that someone is willing to pay for a company,” says Amy Braun-Bostich, CEO and private wealth advisor at Braun-Bostich & Associates

Note that comparing stocks through P/E ratios is an advanced level topic. If you’re new to investing, or don’t want to spend your time researching, most investors can do well with a low-cost, broad-market index fund. Here are our recommendations.

If you’re ready to research, let’s talk about P/E ratios, what they mean, and how they can help you choose the next stock for your portfolio. 

What Is the P/E Ratio?

For stock analysis, P/E ratios is one of the most widely used tools by investors to value a stock, and it helps the investor determine whether that stock is overvalued, fairly valued, or undervalued, explains Thomas Muñoz, associate financial life advisor at Telemus, a financial advisory firm. “As an investor, it helps answer the question of ‘Am I buying this stock at a reasonable price?’”

The higher the number, the more overvalued the stock is. Many investors prefer a lower P/E ratio, which could mean the stock is undervalued and represents potential for higher returns for each dollar you invest in the company. 

Pro Tip

Calculating a company’s P/E ratio is a high level way of looking at an investment portfolio. While it might be good for some investors, it may be confusing for others. Consider low-cost, broad-market index funds to keep the confusion down.

What Are Examples of P/E Ratios? 

There are a few different versions of P/E ratios. You can use a ratio that looks backward, forward, or selects from a certain period of time. 

The backward-looking version is called the trailing P/E ratio, and uses earnings from the past 12 months to calculate the ratio. The idea is to use the company’s recent performance to decide if you want to invest. 

The forward-looking version is the forward P/E ratio, which uses future estimates and projections to guide investment decisions. Your calculations may be for the current fiscal or calendar year, the upcoming year, or even the next quarter.

Most investors want to review the forward P/E ratio. “The reason for that is because you want to focus on where the company’s earnings are going, and you don’t necessarily want to focus on where they were in the past,” Muñoz explains. “You can compare it to historical earnings to understand what might be expected for future earnings.” 

Or, you can choose your own period of time and go from there. For example, if a recent event triggered an upswing for stocks in a certain sector, you might use that date and compare various companies to see how their stock prices adjusted. 

Why Is the P/E Ratio Important?

The P/E ratio gives you an idea of how much, as an investor, you’ll need to invest for every $1 in earnings. “This is a quick and easy evaluation metric to calculate and compare a stock and its peers,” says Muñoz. 

For example, if the P/E ratio is 10, that means for every $10 you invest, you can reasonably expect to earn $1 back. If the P/E ratio is higher, you’ll need to invest more for every $1 in earnings. And if it’s lower, you don’t need to invest as much for every $1 in returns. 

That’s why investors like to hunt for low P/E ratios: so they can get a good deal on an undervalued company. 

But, the P/E ratio doesn’t tell you if a stock is growing, losing money, or has a lot of debt, Braun-Bostich says. Many startups and growth stocks have “astronomical” P/E ratios, she says. That’s why it’s important to also take other data into account. 

What Is a Good P/E Ratio?

That depends on the sector, and can even depend on the company. 

One sector might have P/E ratios in the 30s and consider that a good number, while other industries could have typical P/E ratios in the 20s or even 10s. “The S&P 500 is around 26,” Braun-Bostich says. “That’s about 62% higher than average.”

That’s why, when you calculate P/E ratios, you want to compare companies within the same sector, or even use the sector’s average P/E ratio to see where the company falls on the bell curve. 

It could also be helpful to take a company’s P/E ratio and compare it to where it was at the same point in the past. For example, you could compare a company’s Q4 performance over the past five years to see if it’s moving up, down, or holding steady. This can give you an idea if the company is becoming overvalued or if it’s becoming a better deal over time. 

You can also take the same points from several companies in the same industry to see if performance affected the entire sector or just a few companies in the sector. If a company consistently outperforms through all types of market conditions, you might’ve found yourself a winner. 

The most important thing is to make sure you’re using the same metrics so you have a viable comparison. If you’re using a trailing P/E ratio, use that data in all your calculations so you get an accurate overall view. Or if you’re choosing your own points, keep them consistent. 

How Do You Calculate the P/E Ratio?

The formula for P/E is the price per share/earnings per share (EPS).

It’s easy to find a stock’s price on pretty much any stock screener, but you might have to dig around for the EPS – or calculate it yourself. 

The EPS is the company’s total profit divided by the value of their outstanding shares. As an example, say a company is worth $8 billion and has 4 billion outstanding shares. That divides to $2 in earnings per share. Take that number and plug it into the P/E formula. 

If the current stock price is $40 per share, you’d get $40/$2, for a P/E ratio of 20. You can then check if the company is overvalued or undervalued compared to others in the sector. 

Using the same example, this also means that you can reasonably expect to earn $1 for every $20 you invest because the P/E ratio is 20. 

P/E vs. Earnings Yield

Earnings yield is the inverse of the P/E ratio. Instead of dividing the stock price by the EPS, you divide the EPS by the stock price. This makes it easier to see potential returns, says Muñoz, whereas the P/E ratio is used to value a specific company. 

If a first stock is priced at $40 and has a $2 EPS, the P/E is 20 and the earnings yield is 5%. And if a second stock costs $30 and has a $3 EPS, the P/E is 10 and the earnings yield is 10%. 

In this example, the second stock has a lower P/E and a higher earnings yield. The P/E ratio says you can expect $1 from every $10 you invest, and seeing it expressed as a percentage shows you the returns are higher, which is always a good thing for investors. 

P/E vs. PEG Ratio

The price/earnings to growth (PEG) ratio is another way to predict if a company is overvalued or undervalued. It’s the P/E ratio divided by the growth rate for a specified period of time. 

The PEG ratio adds expected growth into your calculations, which is helpful for analyzing future performance for your investments. 

If a stock has a P/E ratio of 30 and growth of 15%, the PEG ratio is 2. If a different stock has a P/E ratio of 20 with 20% growth, the PEG ratio is 1, which means the latter stock could be undervalued compared to the former, and growing faster. 

When calculating PEG ratios, you’ll want to be consistent with your metrics and timeline for expected growth. If you’re using last year’s data and next year’s future growth, for example, you’ll want to use those same numbers for all your comparisons to get the best idea of which investment would be best for you. 

It’s a good idea to use a few different calculations while you’re researching. “If you’re a do-it-yourselfer, you should really get familiar with these metrics to help guide you,” Braun-Bostich advises. There are lots of factors that drive a stock’s price, and comparing a few calculations will provide a more complete view of the company’s performance. 

Bottom Line

Remember, calculating P/e ratios is for advanced level investors, so if this seems a bit complicated, don’t worry. It is. If you don’t want to worry about calculating whether companies are overvalued or undervalued, a low-cost broad index market fund is a great bet. It takes the guesswork out of investing, and makes it simpler to get started.