What is the P/E Ratio? And How to use it?

P/E Ratio is an abbreviation of Price-to-Earnings Ratio, which represents the ratio of a company’s market capitalization to the company’s net profit, or it can be calculated by using the ratio of a company’s stock price to its Earnings Per Share (EPS ).

The P/E ratio is one of the most widely used indicators for stock valuation. The P/E ratio can be understood as the number of years required to get the investment back.

For example, if a company has a P/E ratio of 15, it means that its current stock price is 15 times its earnings per share. Based on the current profitability, it would take approximately 15 years to get the investment back.

A high P/E ratio indicates that the company’s stock is currently highly sought after, with a large number of investors having already purchased the stock.

Conversely, a low P/E ratio suggests that the investors have little interest in the company’s stock.

It is important to note that a high or low P/E ratio does not inherently indicate good or bad investment value. The P/E ratio is most valuable when used to compare a company’s historical P/E data or to compare the P/E ratios of different companies within the same industry.

Below is Charles Schwab’s explanation of the P/E ratio:

How to calculate the P/E ratio?

Market Cap Method

P/E ratio = Market Cap ➗ Net Profit

where:

• Market Capitalization (Market Cap): This can be obtained by multiplying the stock price by the number of shares outstanding.
• Net Profit: This is the company’s annual net profit, which can be found in the company’s financial statements, specifically the income statement.

Let’s take Apple Inc. (AAPL) as an example to see how to calculate the company’s P/E ratio.

We need to find the company’s market value and its annual net profit. It is important to note that companies report their net profit every quarter and annually.

In the annual report (10-K) published by Apple Inc. in September 2023, the annual net profit is reported as $96.995 billion.

On July 8, 2024, Apple’s closing stock price was $227.13, and its market value (Market Cap) was $3,480 billion.

Therefore, the P/E ratio for Apple is calculated as follows: P/E Ratio=3480 billion96.995 billion≈36\text{P/E Ratio} = \frac{3480 \text{ billion}}{96.995 \text{ billion}} \approx 36P/E Ratio=96.995 billion3480 billion​≈36

This means that the investment cost for every $1 of earnings is $36. In other words, based on the current earnings, it would take 36 years to recover the investment cost.

By using Apple’s market value and net profit data over the past ten years, one can plot the trend of its P/E ratio over the last decade.

Per Share method:

P/E ratio = Stock price ➗ Earnings Per Share

Earnings Per Share, often abbreviated as EPS, is calculated using the following formula:

EPS = Net Profit ➗ Shares Outstanding

The second calculation method is essentially the same as the first. Dividing the market capitalization by the total shares outstanding gives the stock price, and dividing the net profit by the shares outstanding gives the earnings per share (EPS).

What is the significance of the P/E ratio?

The higher the P/E ratio, the higher the stock price relative to its earnings. Conversely, the lower the P/E ratio, the cheaper the stock is considered to be.

The P/E ratio is an important tool for valuing individual stocks or stock indices (such as the S&P 500).

A high P/E ratio may indicate that the stock price is very high relative to its earnings and could be overvalued. On the other hand, a low P/E ratio may suggest that the current stock price is low relative to its earnings and could be undervalued.

When analyzing the value of a stock, in addition to tracking the changes in the P/E ratio of a single stock, you can also compare the P/E ratios of similar companies within the same industry to determine the relative value of the stock price.

What are the types of P/E ratios?

When calculating the P/E ratio, the meaning can vary depending on the period used for the market value or net profit:

1. TTM P/E Ratio

TTM P/E Ratio, or Trailing Twelve Month P/E Ratio, indicates the P/E ratio of a company over the most recent 12 months.

When calculating the P/E ratio using the company’s net profit (denominator) over the past 12 months, the resulting P/E ratio is called the TTM P/E ratio.

TTM P/E Ratio = Market Cap ➗ Net Profit over the last 12 months

The TTM P/E ratio uses the company’s earnings data from the most recent 12 months to calculate the P/E ratio, making it an objective and accurate value for evaluating the company rather than a subjective prediction.

Therefore, the TTM P/E ratio is the most popular P/E ratio indicator because it is the most objective.

Using Apple Inc. as an example, when we previously calculated the P/E ratio, we used the net profit from the annual report published in September 2023, which represents the net profit from September 2022 to September 2023.

To calculate the TTM P/E ratio, we need to find the most recent four quarterly reports and calculate the net profit for the latest 12 months.

Apple’s most recent four quarterly reports were released in June 2023, September 2023, December 2023, and March 2024, with the net profit as follows:

Apple’s market capitalization on July 8, 2024: $3,480 billion

So, Apple’s P/E ratio = $3480 billions / $100.389 billions = 35

Popular investment tools, such as Interactive Broker, Futu Moomoo, and Robinhood, also provide TTM P/E ratio.

2. Shiller P/E ratio

The Shiller P/E ratio, also known as the Cyclically Adjusted P/E Ratio (CAPE), is calculated using the average earnings over a period of time.

It was introduced by Yale University professor Robert Shiller and was originally used to assess the valuation of the entire stock market.

The Shiller P/E ratio is calculated by dividing the current market value of a company by the average inflation-adjusted net profits over the past ten years.

Shiller P/E ratio = Market Cap / 1o-Year Average of Inflation-Adjusted Net Profit

Using Apple Inc. as an example, the chart below shows Apple’s Shiller P/E ratio over the past ten years.

From the chart, it can be seen that Apple’s Shiller P/E ratio reached its lowest point in nearly ten years in 2016, while it reached its highest point in nearly ten years at the end of 2021.

In addition to being used for valuing listed companies, the Shiller P/E ratio is widely used to assess the valuation of the S&P 500 index.

3. Forward P/E Ratio

The Forward P/E ratio uses the company’s future operating performance and stock price projections to calculate the P/E ratio. It is a forecast of the company’s future performance.

The downside of this method is that any predictions about the future can never be 100% accurate.

What is the ideal P/E ratio?

The P/E ratio is a ratio, and it is difficult to say what the best P/E ratio is. It only becomes useful when comparing the P/E ratios of different companies or the P/E ratios of the same company at different times.

At the same time, the P/E ratio is not very suitable for cyclical industries such as aviation, real estate, and finance.

When investors use the P/E ratio to analyze a company’s stock price, they often consider multiple different companies within the same field and compare their P/E ratios.

For example, Stock A is trading at $30, and Stock B is trading at $20. At first glance, Stock A seems more expensive, but using the P/E ratio can help investors determine which one is cheaper from a valuation perspective.

Here we calculate the P/E ratio of Stock A and Stock B using their earnings per share (EPS):

• Stock A: Stock Price = $30; EPS = $2; P/E Raito = 15
• Stock B: Stock Price = $20; EPS = $1; P/E Raito = 20

Based on the P/E ratio, Stock A may be a better buy because it has a lower P/E ratio and higher earnings per share.

Therefore, when investing, one cannot judge the investment value of a stock solely based on its price.

Additionally, it is worth noting that the P/E ratios can vary across different industries. Some industries have higher average P/E ratios, while others have lower averages. Therefore, comparing P/E ratios across industries is not very meaningful.

The P/E ratio is just one of many valuation indicators and financial analysis tools used to guide investors in making investment decisions. You may also need to consider the following indicators:

• Price to Book Ratio
• Price to Sale Ratio
• Enterprise Multiple
• EV/EBITDA
• Price/Earnings-to-Growth Ratio

The P/E ratio can also be used to calculate the P/E ratio of U.S. stock indices, such as the S&P 500 index, to evaluate the overall stock market condition.

How to Use the P/E Ratio to Guide Investments?

To determine whether a stock is worth buying based on its P/E ratio, you can compare the current P/E ratio of the stock with its long-term average P/E ratio.

For example, if a company’s stock price in 2022 is $30 and its long-term average EPS is $2, then the stock’s long-term average P/E ratio is 15.

If the company’s stock price remains at $30 in 2023, but due to increased sales, its EPS rises to $2.5, the current P/E ratio decreases to 12.

This indicates that the current stock price is cheaper than its long-term price because the EPS has increased while the stock price has remained the same, meaning the P/E ratio has decreased, making it a good time to buy.

Another way to judge whether a stock price is too high or low based on the P/E ratio is to compare it with other companies in the same industry.

For instance, if you want to invest in a company that produces cookies and the average P/E ratio for the entire cookie production industry is 10, but one cookie production company has a P/E ratio of 15, then that company’s stock price is relatively expensive.

It is important to emphasize once again that the P/E ratio is a value that needs to be compared to reflect its guidance value, and this value can be influenced by many factors.

A high P/E ratio does not necessarily mean the stock is too expensive, nor does a low P/E ratio necessarily mean it is cheap.

What might the P/E Ratio Indicate?

It is important to note that if a stock’s P/E ratio is significantly higher than that of similar companies in the same industry, or even higher than its own historical P/E ratio, this might suggest that the stock is overvalued.

Conversely, a low P/E ratio may suggest that the company’s current stock price is undervalued, which could be a good signal to buy the stock.

However, it is crucial not to rely solely on a low P/E ratio to determine that a stock is undervalued. This could be due to a decline in the company’s profitability, leading investors to have a pessimistic outlook on its future earnings.

Therefore, for stocks with a low P/E ratio, it is necessary to analyze the company’s earnings situation further to determine whether the low P/E ratio is a signal of a good investment or if it indicates a stock that is truly not worth investing in.

How to check historical P/E ratios?

You can use tradingview to look up the historical P/E ratios of listed companies:

For example, let’s search for Apple’s historical P/E ratio:

Step 1: visit tradingview and type the stock ticker. For example, Apple’s ticker is AAPL. Then mouse over the first one in the drop-down menu and select the blue button [See Overview].

Step 2: On AAPL’s information page, click [Financials].

Step 3: Keep scrolling down the page to view the company’s current P/E ratio and historical data.

What is the Difference Between the P/E Ratio and the PEG Ratio?

PEG, or Price/Earnings-to-Growth, also known as the “dynamic P/E ratio,” is the ratio of a stock’s P/E ratio to its net profit growth rate.

Generally, it is considered that stocks with a PEG ratio of less than 1 are undervalued because their P/E ratio is low compared to their earnings growth.

Conversely, a PEG ratio greater than 1 may be viewed as overvalued because the P/E ratio is high relative to the earnings growth.

However, if a company pays dividends, the PEG ratio might not be as applicable because the PEG ratio does not take dividends into account.

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