Evaluating the value of stocks is a complex task. It’s easy to get lost among the plethora of financial metrics.

To help you get started, we explain everything you need to know about Warren Buffett’s favorite measure.

Read on to find out what the meaning of P/E ratio is, how to calculate it, and how to interpret and use it.

**What Does P/E Ratio Mean****?**

The meaning of P/E ratio is **price-to-earnings**. It’s also known as **price multiple** or **earnings multiple**.

It measures the value of a company's stock or the current share price (P) relative to its earnings per share (EPS). In other words, it shows **how much you pay for a unit of earnings**.

Let’s break down the definition to get a better idea of what the P/E ratio is.

**Stock prices** are determined by supply and demand. The changes are dynamic and depend on a multitude of economic factors. When there’s high demand, the value of a company’s stock goes up.

The **earnings per share** reflect the company’s net profit relative to its outstanding shares. Generally, the higher it is, the better.

Now, back to the P/E ratio definition.

If the share price is high and the EPS is low, then the stock is overvalued, and vice versa. So, the P/E can show you whether you’re paying what the stock is worth.

**P/E Ratio Formula**

To find the ratio, you must **divide the current stock price (P) by the earnings per share (EPS)**.

**P/E = P / EPS**

The P/E formula is quite intuitive, really. All you have to do is find the numbers.

The **stock price** is easy to find. A quick Google search will do. You can also look it up in any financial instrument by entering the stock’s ticker symbol.

The **EPS** is a bit more complex. For the purposes of the price-to-earnings ratio formula, we are interested in two variants of the metric.

The first one is called **TTM, or trailing 12 months**. It is a summary of the company’s past performance.

Some analysts use the past 12 months, while others—the fiscal year. Either way, the ESP is calculated before dividend payments are distributed.

The other one is based on the company’s projections of its future performance. It’s an internally-produced measure known as **forward earnings guidance**. You can find it in a firm’s earnings release.

Depending on the EPS you use, you’ll get different types of P/E ratios.

Let’s see what they are.

**Types of ****P/E Ratio**

There are two main types of ratios you can calculate.

The **forward price multiple predicts future performance**. As we mentioned above, it’s based on the forward earnings guidance. Since that’s an internally-produced calculation, dome organizations may want to inflate it to attract more investors.

Others may understate it to report that they’ve surpassed the following quarter’s expectations.

You can also use external projections from experts in your stock analysis. Either way, they’re just estimates, and you should treat them like such.

The **trailing earnings multiple measures past performances**. Typically, it’s calculated for a period of one year. That said, some analysts use 10 or 30 years for a long-term evaluation of stock index performance.

It is more objective than the forward-looking ratio, so experts often prefer it. Still, past performance isn’t always the most reliable predictor of the future.

So, don’t be quick to jump to conclusions about the future of stock with this P/E ratio.

**Usage**

This metric has multiple applications.

But before we dive deeper, let’s see how to interpret the measure. Let’s start with the worst-case scenario.

What does а **negative P/E ratio **mean?

That’s definitely a red flag. The price multiple is negative if the EPS is below zero. This happens if** the company is losing money** or even facing bankruptcy. That said, if the ratio is negative, it usually isn’t reported.

Now, let’s look at the positive values.

A **low ****P/E ratio** could mean one of two things.

It could reveal that investors see **low growth potential** in stock, so they’re not buying it. If the price is low and the EPS decreases over time, that may be the case.

Alternatively, it could be **an indicator of “value” shares** or stocks of high value which are currently underpriced. If the price is low, but other factors suggest the company has high growth potential, it could be a value stock.

A **high ratio** shows that many **investors expect an increase in earnings**. That said, it may be overvalued if it is disproportionately higher than the P/E ratio of other stocks from the same industry.

Here are the main usages of the P/E ratio explained.

**1. Compare the value of businesses from the same industry**

Some industries (e.g., tech) have higher ratios on average than others (e.g., public utilities). This means two things.

First, comparisons of companies from different sectors simply won’t be reliable. Second, it’s hard to give a straightforward answer to the question, “what's a good P/E ratio.”

The **market average is 20-25**. But, as we said, you should always compare it to the industry and use other metrics to determine whether it’s a good P/E.

**2. Evaluate the performance of a single company across a time period (trailing P/E)**

As we mentioned, the TTM reveals a stock’s performance over time. Surely, the past isn’t always a reliable predictor of the future.

But if you calculate the trailing price multiple for 10 years, for example, you can **detect growth patterns**. Even with a P/E ratio calculator, it can take ages to find all the numbers.

Luckily, there’s an alternative measure you can use.

**3. Try to predict future performance (forward P/E)**

If you don’t want to dig through past records, you can use the company’s forward earnings guidance.

That’s a forward-looking measure based on the organization’s (or experts’) predictions about future earnings per share.

Now, let’s see what a P/E calculation looks like in practice.

**P/E Example**

We’ll take Google’s P/E ratio as an example.

To calculate the P/E multiple, we need the stock price and EPS.

As of the end of July 2022, Google’s price per share was $111.3. Its EPS is $5.39. This means that the price multiple is $111.3 / $5.39 = 19.08.

In other words, the stock is trading on a price multiple of 19x, so you will pay $19 for $1 of earnings.

However, that number alone doesn’t tell us much. Since Alphabet is part of the NASDAQ, we can compare it to the other companies in that index.

As of July 2022, the NASDAQ 100 P/E ratio was 25.75. This shows that Alphabet’s P/E is a little below the average but can’t be considered low per se.

To determine whether to buy it, though, you need to check out other metrics, like debt, profit, dividend yield, and so on.

**P/E Limitations**

- There are several types of EPS, and you can’t make comparisons unless you use the same one. Also, a forward-looking P/E and a TTM tell completely different stories. So, you need to be mindful of the metrics used in the calculations.
- The stock prices and EPS fluctuate greatly, affecting the price-to-earnings ratio. As such, you should always take the price multiple for a longer period to obtain meaningful information.
- The EPS doesn’t necessarily reflect the companies’ financial standing accurately. You need to combine it with other metrics, like ROE, D/E ratio, and so on, to evaluate the profit and potential for growth.

**Wrap Up**

Above, we discussed the meaning of P/E ratio and explained how to interpret it. You are now equipped to conduct analysis and make well-informed investment decisions.

Just remember to use several metrics to get the full picture before buying a stock. The P/E is useful but not very meaningful on its own.

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With an eye for research, Aleksandra is determined to always get to the bottom of things. If there’s a glitch in the system, she’ll find it and make sure you know about it.