P/E Ratio (Price-to-Earnings)
Definition
A valuation metric calculated by dividing a stock's price by its earnings per share, indicating how much investors are willing to pay for each dollar of earnings.
The Price-to-Earnings ratio is one of the most widely used stock valuation metrics. A P/E of 20 means investors are paying $20 for every $1 of annual earnings. It serves as a quick gauge of whether a stock is relatively expensive or cheap compared to its earnings power.
There are two common versions: trailing P/E uses the last 12 months of actual earnings, while forward P/E uses analysts' estimates for the next 12 months. Forward P/E is more forward-looking but depends on the accuracy of earnings forecasts. Both are valuable for different analyses.
Context matters enormously when interpreting P/E ratios. A "high" P/E (say, 40) might be justified for a fast-growing company that's expected to double earnings in a few years. A "low" P/E (say, 8) might reflect that the market expects declining earnings or significant business risks.
Industry comparisons are essential. Technology stocks historically trade at higher P/E ratios than utility stocks because of faster growth expectations. Comparing a tech company's P/E to a utility company's is meaningless; compare it to other tech companies or the company's own historical P/E.
The S&P 500's average P/E ratio has historically been around 15-16, though it has been significantly higher in recent years due to low interest rates and technology sector dominance. The cyclically adjusted P/E (CAPE or Shiller P/E) smooths out business cycle effects by using 10 years of inflation-adjusted earnings.
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Frequently Asked Questions
What's a good P/E ratio?
There's no universal 'good' P/E. It depends on the industry, growth rate, and interest rate environment. Generally, a P/E below 15 might indicate value, while above 25 suggests growth expectations. Always compare P/E within the same industry and consider the company's growth rate.
Can P/E ratio be negative?
Technically yes — when a company has negative earnings (losses), the P/E would be negative. However, negative P/E ratios aren't meaningful and are usually not reported. For unprofitable companies, analysts use other metrics like Price-to-Sales or Price-to-Book value.