What is a PE Ratio?

How much does one dollar of profitability cost?…

That’s the P/E ratio. It's a tool to help investors understand how expensive a stock is by pegging it to a dollar of profitability. That can be more useful than pegging a stock’s value to the price of a share, since the value of a share depends on other things, like how many shares are there in total.

The P/E ratio comes from simple division:

The stock price is easy to find for publicly traded companies — They update them live on their investor relations websites and they’re also available on plenty of financial news websites, such as Google Finance, Yahoo Finance, the Wall Street Journal, or Robinhood.

The earnings per share isn’t quite as clear-cut. Companies publish their earnings — also referred to as “profits” or “net income” — both quarterly and annually. The earnings per share needed for the P/E ratio is its annual earnings. That can be found in the company’s most recent annual earnings report, but that could be outdated at the time that you need it. For example, a company could publish its annual report after December 31st each year. If it’s November, then the best data you have is already 11 months old. For that reason, investors and analysts like to use earnings from the “TTM,” or “trailing twelve months.” To get that, you can patch together the earnings from the last four quarterly reports, even if they straddle two different years.

For example: Let’s try this out by calculating the P/E ratio for McDonald’s.

Stock price: the stock price for McDonald’s on June 13, 2019 was $204.

Earnings per share: McDonald’s earnings per share for the last four quarters were:

• (The quarter ending) Mar 2019: $1.74
• Dec 2018: $1.82
• Sept 2018: $2.12
• June 2018: $1.92

TOTAL: Earnings per share for the trailing twelve months = $7.60

P/E ratio: = $204/$7.60 = 26.84

Note: the source of these data are McDonald’s quarterly earnings reports, found on its investor relations’ website.

Unlike salary or the number of cherries on an ice cream sundae, a high or low P/E ratio isn’t necessarily a good or bad thing. It’s not that black and white. A company’s P/E ratio though tells you about how investors value a company. Do they think profits will grow in the future, stay the same, or maybe shrink?

A low P/E = expectations that profits could shrink in the future. Think about the horse industry. Before the car was invented, owning stock of a horse ranch may have been profitable — If there were a stock for “Horse Inc.” it may have had a high price. But then the car was invented. Investors might have sold shares of Horse Inc. on expectations that future profits would shrink. As the stock price fell, that would cause the P/E ratio of Horse Inc. to fall.

A high P/E = expectations that profits could increase in the future. Let’s jump back on the horse analogy. When cars were invented, the stock of “Cars Inc.” probably would likely have risen as investors recognized the potential for these 4-wheeled moving things. The stock could have risen before profits even materialized. That higher stock price would have caused the P/E ratio to rise.

As an investor, it’s helpful to know what the rest of the market thinks about this stock. You might agree, or you might disagree. And your investing decisions can grow from there.

Benchmarks are useful. It’s something you can compare to in order to understand relative size. Unless you have a frame of reference to compare something — a benchmark — it’s much harder to know if something is bigger or smaller, or compare anything at all.

Using a stock market index as a benchmark: We can calculate the P/E ratio of the S&P 500, which gives us a sense of how “expensive” stocks are in the market in general. Comparing one stock’s P/E ratio to the S&P 500’s lets you understand if a P/E ratio is relatively high or low.

Using a stock sector as a benchmark: You can also compare the P/E ratio to the average for that sector. For example: comparing Ford’s PE ratio to the average P/E for car companies helps you determine how Ford’s stock price compares to its peers.

Using another company as a benchmark: If you’re deciding between two stocks to invest in, knowing the P/E ratio’s of them is just another way to help you make a decision. It tells you which is more “expensive” than the other, and gives you a signal of what investors think about the two stocks’ future profits.

You might be telling yourself it’s easy to measure how “expensive” a stock is — Just look at the stock price. But that’s not as useful as P/E ratio. The stock price is the value of a stock. But what is a stock? It’s one ownership share of a company — Its value depends not only on the company’s value, but also on the number of shares there are. Think about pizza. Is a $1 piece of pizza expensive? It depends how big the piece is. You need to think how big the piece of stock is, too.

P/E ratio controls for the size of the “piece of pizza” by calculating how much a stock costs per dollar of earnings. No matter what company’s P/E ratio you’re looking at, you see the price of one dollar worth of their earnings.

In the example above (McDonald’s), we calculated earnings per share based on the trailing twelve months. But since the P/E ratio tells us something about what investors think about the stock’s future, sometimes it makes sense to compare the stock price to the next twelve month’s earnings — this is called “forward earnings.” To measure forward earnings, you can either use the company’s official profit forecasts (not all companies tell us this) or you can use what stock analysts think.

What if the PE ratio is negative?: If the company is unprofitable, then its earnings per share are negative. A company that consistently has a negative PE ratio for a long period of time may not be in that good financial health.

Disclosure: It is not possible to invest directly in a market index. Indices are not subject to any fees or expenses.