The ratio is computed by taking market price per common share divided by earnings per share.

What is the Price Earnings Ratio?

The price earnings ratio compares the market price of a company's stock to its earnings per share. This ratio reveals the multiple of earnings that the investment community is willing to pay to own a company's stock. A very high multiple indicates that investors believe the company's earnings will improve dramatically, while a low multiple indicates the reverse.  If the ratio is already high, then there is little chance for the stock price to move even higher, so there is significant risk that the share price will slide lower in the future.

The investment community usually forces a stock price upward based on future expectations for such issues as new patents, new products, changes in the laws impacting a company, and so forth.

It is possible to build an expected price earnings ratio by dividing future earnings expectations per share into the current market price. This is not a firm indicator of where the ratio will actually be in the future, but is a good basis for deciding whether the stock is undervalued or overvalued.

If a company is currently reporting a loss, then it has no price earnings ratio at all.

How to Calculate the Price Earnings Ratio

The price earnings ratio can be derived as either the current market price per share, divided by earnings per share, or as the total current company market capitalization, divided by net after-tax earnings.  The earnings listed in the denominator of the ratio are for the preceding 12 months. The results of either calculation are the same. The formula using individual share information is:

Current market price per share ÷ Earnings per share

The earnings per share in the denominator are based on diluted earnings per share.

The formula using full-company financial information is:

Current company market capitalization ÷ Net after-tax earnings

Example of the Price Earnings Ratio

ABC International's common stock is currently selling for $15 per share on the open market. It reported $3.00 of diluted earnings per share in its last annual report. Therefore, its price earnings ratio is:

$15 Market price per share ÷ $3 Earnings per share

= 5 price earnings ratio

Problems with the Price Earnings Ratio

There are several issues to be aware of if you elect to use this ratio. Areas of concern are as follows:

• Earnings information can be manipulated by accelerating or deferring expense recognition, as well as a variety of revenue recognition schemes. A more accurate measure of the value that the investment community is placing on a company's stock is the price to cash flow ratio. Cash flow is a much better indicator of the results of a company's operations.

• Changes in the price earnings ratio tend to impact every company in an industry at the same time, because they are all subject to the same market forces, with slight differences between the various companies. Thus, a favorable change in the price earnings ratio may not be cause for excessive jubilation at one company for a job well done, since the change may not be caused by the company at all, but by a change in its business environment.

• Yet another issue with the price earnings ratio is that the price may fluctuate wildly in the short term, as such factors as takeover rumors and large customer orders excite investors and impact the price. Consequently, the ratio can be dramatically different if the timing of the measurement varies by just a few days.

Terms Similar to Price Earnings Ratio

The price earnings ratio is also known as the earnings multiple or price multiple. The price earnings ratio is sometimes referred to as the multiple, because it states the multiple of earnings per share that investors are will to pay for a stock.

Computing a stock's price-to-earnings (P/E) ratio is one of the quickest ways to learn whether a company is overvalued or undervalued. If a company's stock is undervalued, then it may be a good investment based on the current price. If it is overvalued, then you need to evaluate whether the company's growth prospects justify the stock price.

What is the price-to-earnings ratio?

The P/E ratio measures the relationship between a company's stock price and its earnings per issued share. The P/E ratio is calculated by dividing a company's current stock price by its earnings per share (EPS). If you don't know the EPS, you can calculate it by determining the company's earnings (subtract the company's preferred dividends from its net income) and then dividing the earnings by the number of shares outstanding.

P/E ratio example

Let's say a company has net income of $1 billion, it pays $200 million in preferred dividends, and it has 400 million shares outstanding. Here's how we'd calculate its EPS:

($1 billion-$200 million) / 400 million shares = $2 per share

Now that we know the EPS, we can compute the P/E ratio. If the stock currently trades for $30 per share, then the P/E ratio would simply be $30 divided by $2, or 15.

How to use the P/E ratio to evaluate stocks

When you start your analysis, take a look what type of company you're investigating. A good P/E ratio in one industry or asset class can be bad in another. If you're looking for a value stock, you want the P/E ratio to be low. The opposite is actually true of growth investments. If a company has high-flying earnings, it's likely a lot of investors will want to buy its stock.

The P/E ratio is useful, but don't rely only on this ratio for your stock purchase decisions. There are companies with low P/E ratios for which the P/E ratio will drop even more, and vice versa.

If you invert the P/E ratio, you can find out the earnings yield, which represents your share of earnings for every share you own.

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P/E ratio limitations

The biggest limitation associated with the P/E ratio is the potential for earnings distortions. The earnings in earnings per share are based on the generally accepted accounting principles (GAAP) for net income, which means that GAAP-compliant earnings are not always a great indicator of the profitability of a business. If a business is adding or deducting significant non-cash expenses such as business unit sales or depreciation, then its GAAP net income can fluctuate greatly.

Capital efficiency matters, but P/E ratios don't take this factor into consideration. If a manufacturing company requires $50 in capital to produce $1 in earnings, then it shouldn't be worthy of the same ratio as a technology company that requires just $3 in capital to produce $1 in earnings.

You can compute additional ratios to make up for some of these limitations. Ratios such as enterprise value/free cash flow, price/sales (P/S) or price/book (P/B) value may be better for certain industries. Research which ratio is common to the industry before you conduct your analysis.

Related investing topics

Comparing P/E ratios

Here are the best comparisons to use for the P/E ratio:

Peers

For the most part, competitors in an industry have similar businesses and earnings models. That means P/E ratios in the industry should be around the same, and differences to the positive likely reflect business quality or growth potential. If you think a company has a superior business but it still has a low P/E ratio, then it may be a good investment.

History

Looking at a stock's P/E ratio history is one of the best ways to avoid buying stocks with perpetually low P/E ratios. If a value stock's P/E ratio is unfavorable and has been for years, then what's the specific catalyst that will make it trade at higher prices in the future? If a growth stock is trading at its highest-ever P/E ratio, but the growth rate is starting to decline, then the stock's price may soon fall.

If a company is close to the beginning of its life cycle and is still proving out its business model, you can expect multiple expansions by the company over the coming years and may be willing to accept a high P/E ratio. If a company is a slow- or no-growth stalwart, be wary of multiple contractions and accept only low P/E ratios.

Growth

Since a company that is growing rapidly may be worth a high P/E ratio, you can compare among ratios by also calculating a company's P/E ratio as a multiple of the company's projected earnings growth rate. Simply divide a company's P/E ratio by either the earnings growth rate from the past few years or an analyst-supplied projection for the next few years. Companies with low — say, below 1 — P/E-to-earnings-growth (PEG) ratios may be worth somewhat higher P/E ratios.

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