P/E Ratio: Price vs Earnings
The P/E ratio is the most famous metric in investing. Let's understand it deeply.
The Formula
P/E Ratio = Stock Price ÷ Earnings Per Share (EPS)
Example:
- Stock price: $100
- EPS: $5
- P/E = 100 ÷ 5 = 20
This means you're paying $20 for every $1 of annual earnings.
The Rental Property
Imagine buying a rental property:
- Price: $200,000
- Annual Rent (profit): $10,000
- "P/E": 200,000 ÷ 10,000 = 20
It would take 20 years of rent to "pay back" the purchase price.
A P/E of 20 for a stock means the same thing—20 years of current earnings to equal the price you paid.
What P/E Tells You
| P/E Level | General Interpretation |
|---|---|
| Below 10 | Very cheap (or troubled company) |
| 10-15 | Cheap to fair |
| 15-20 | Fair (market average) |
| 20-30 | Somewhat expensive |
| 30-50 | Expensive (high growth expected) |
| 50+ | Very expensive (extreme growth expected) |
| Negative | Company is losing money |
Types of P/E
Trailing P/E (TTM)
- Uses past 12 months of earnings
- Based on actual, reported numbers
- Most common type
Forward P/E
- Uses estimated future earnings
- Based on analyst projections
- Shows what investors expect
Example:
- Trailing P/E: 25 (based on last year's $4 EPS)
- Forward P/E: 20 (based on expected $5 EPS next year)
The lower forward P/E suggests analysts expect earnings to grow.
Key Takeaways
- P/E = Price ÷ Earnings Per Share
- Lower P/E generally means cheaper (but not always better)
- Compare P/E within the same sector
- Trailing P/E uses past earnings; Forward P/E uses estimates
Why P/E Varies by Sector
Different industries have different "normal" P/E ranges:
| Sector | Typical P/E Range | Why |
|---|---|---|
| Technology | 25-40 | High growth expectations |
| Healthcare | 20-35 | Growth + defensive |
| Financials | 10-15 | Mature, regulated |
| Utilities | 15-20 | Stable, slow growth |
| Consumer Staples | 18-25 | Defensive, steady |
Key insight: A P/E of 30 is cheap for a fast-growing tech company but expensive for a utility.
The PEG Ratio
To account for growth, investors use the PEG Ratio:
PEG = P/E ÷ Growth Rate
- PEG < 1: Potentially undervalued for its growth
- PEG = 1: Fairly valued for its growth
- PEG > 1: Potentially overvalued for its growth
Example: P/E of 30 with 30% growth = PEG of 1 (fair)
P/E Limitations
1. Earnings Can Be Manipulated
Accounting tricks can inflate or deflate earnings temporarily.
2. Doesn't Work for Unprofitable Companies
No earnings = no P/E (or negative P/E).
3. Ignores Balance Sheet
A company with tons of debt might look cheap on P/E but be risky.
4. Backward-Looking
Trailing P/E tells you about the past, not the future.
How ShareValue.ai Uses P/E
We don't just look at raw P/E. We:
- Compare to sector average — Is it cheap vs. peers?
- Consider growth — Is low P/E justified by slow growth?
- Combine with other metrics — P/E is one input, not the only one
- Track changes — Is P/E expanding or contracting?
P/E Traps
- Buying just because P/E is low (might be a value trap)
- Avoiding stocks just because P/E is high (might be justified by growth)
- Comparing P/E across different sectors
- Ignoring why P/E is low (earnings might be about to drop)
Quick P/E Checklist
Before using P/E to make decisions:
- Is the company profitable? (P/E only works with positive earnings)
- Am I comparing within the same sector?
- Have I considered the growth rate?
- Is this trailing or forward P/E?
- Are there any one-time items affecting earnings?
Next up: P/B Ratio—another essential valuation tool.