The P/E Ratio: What It Tells You and What It Hides

The price-to-earnings ratio is the most quoted valuation measure in finance. You will see it in every market report (“the S&P 500 trades at 22 times forward earnings”). It is useful, but only if you know its limits.

The basic idea

P/E = share price ÷ earnings per share.

If a stock trades at $100 and the company earned $5 per share over the past year, its P/E is 20. You are paying $20 for every $1 of annual profit.

Another way to see it is the earnings yield, which is simply the inverse: 5 ÷ 100 = 5%. That makes it easy to compare with bond yields. A stock with a P/E of 20 earns 5% of its price each year — though, unlike a bond coupon, that profit is not paid to you in full and can grow or shrink.

Trailing vs. forward

• Trailing P/E uses the past 12 months of reported earnings. It is factual but backward-looking.
• Forward P/E uses analysts’ estimates of the next 12 months’ earnings. It looks ahead but depends on forecasts that can be wrong — often optimistic.

Always check which one you are looking at. For a growing company, forward P/E will be lower than trailing P/E.

What a high or low P/E means

A high P/E means investors are paying a lot for current profits, usually because they expect those profits to grow fast. A low P/E means they expect slow growth, high risk, or trouble ahead. The P/E is a price of expectations, not a verdict on quality.

That is why comparing P/Es only makes sense among similar companies. A software company growing 25% a year and a utility growing 3% should not trade at the same multiple.

Five reasons a low P/E can mislead

1. Earnings are at a cyclical peak. Steelmakers, carmakers and banks often look cheapest at the top of the cycle, just before profits fall.
2. One-off gains — an asset sale, a tax benefit — inflate earnings temporarily.
3. Accounting choices. Adjusted earnings can exclude real costs.
4. Debt. P/E ignores the balance sheet. Two companies with the same P/E can have very different debts. Enterprise value-to-EBITDA (EV/EBITDA) accounts for debt.
5. Declining business. A company whose profits are shrinking deserves a low multiple; this is often called a “value trap”.

And when earnings are negative or near zero, the P/E is meaningless.

The Shiller CAPE

To smooth out the business cycle, economist Robert Shiller popularized the cyclically adjusted P/E (CAPE): price divided by the average of the past 10 years of earnings, adjusted for inflation. High CAPE readings have historically been followed by lower average returns over the subsequent decade, and low readings by higher returns.

But CAPE is a poor timing tool. The market can stay “expensive” for years, and changes in accounting rules, interest rates and the mix of companies in the index make comparisons with the distant past imperfect.

Using P/E sensibly

• Compare a company’s P/E with its own history and with close competitors.
• Compare it with expected growth. The PEG ratio (P/E divided by the earnings growth rate) is a rough way to do this.
• Look at several measures — price-to-sales, price-to-free-cash-flow, EV/EBITDA — rather than one.
• Remember that the market P/E reflects interest rates: when bond yields are low, investors accept lower earnings yields on stocks, and vice versa.

The P/E ratio is a starting point for questions, not an answer. A high one asks “Is that growth really coming?” A low one asks “What is the market worried about?”