Stocks with high price-to-earnings (P/E) ratios can be overpriced. So, is a stock with a lower P/E ratio always a better investment than a stock with a higher one? The short answer is no. The long answer is that it depends on the situation. Read on to find out more about price-to-earnings ratios, how to interpret them, the difference between a low and a high P/E ratio, and which one is better.
Key Takeaways
- The P/E ratio is calculated as a stock’s current share price divided by its earnings per share for a 12-month period.
- A stock trading at $40 per share with an EPS of $2 has a P/E ratio of 20, while a stock trading at $40 per share with an EPS of $1 has a P/E ratio of 40, meaning the investor pays $40 to claim $1 in earnings.
- P/E ratios tend to vary from industry to industry, so it is important to compare companies from the same industry and with similar characteristics.
What Is a Price-to-Earning (P/E) Ratio?
The P/E ratio is calculated as a stock’s current share price divided by its earnings per share (EPS), usually for the last 12 months—also called the trailing 12 months (TTM). Most of the P/E ratios you see for publicly-traded stocks are an expression of the stock’s current price compared with its previous 12 months of earnings.
Stocks with high price-to-earning (P/E) ratios can be overpriced.
A stock trading at $40 per share with an EPS of $2 would have a P/E ratio of 20 ($40 divided by $2), as would a stock priced at $20 per share with an EPS of $1 ($20 divided by $1). These two stocks have the same price-to-earnings valuation. In both cases, investors pay $20 for each $1 of earnings.
However, what if a stock earning $1 per share was trading at $40 per share? Then we’d have a P/E ratio of 40 instead of 20, which means the investor would be paying $40 to claim a mere $1 of earnings. This seems like a bad deal, but there are several factors that could mitigate this apparent overpricing problem.
First, the company could be expected to grow revenues and earnings much more quickly in the future than companies with a P/E of 20, thus commanding a higher price today for the higher future earnings. Second, suppose the estimated (trailing) earnings of the 40-P/E company are very certain to materialize, whereas the 20-P/E company’s future earnings are somewhat uncertain, indicating a higher investment risk.
Investors would incur less risk by investing in more-certain earnings instead of less-certain ones, so the company producing those sure earnings again commands a higher price today.
Comparisons Are Necessary
It must also be noted that average P/E ratios tend to vary from industry to industry. Typically, companies in very stable, mature industries that have more moderate growth potential have lower P/E ratios than companies in relatively young, quick-growing industries with robust future possibilities.
Thus, when an investor is comparing P/E ratios from two companies as potential investments, it is important to compare companies from the same industry and with similar characteristics. Otherwise, if an investor simply purchased stocks with the lowest P/E ratios, they would likely end up with a portfolio full of utilities stocks and similar companies, which would leave the portfolio poorly diversified and exposed to more risk than if it had been diversified into other industries with higher-than-average P/E ratios.
However, this doesn’t mean that stocks with high P/E ratios cannot turn out to be good investments. Suppose the same company mentioned earlier with a 40-P/E ratio (stock at $40, earned $1 per share last year) was widely expected to earn $4 per share in the coming year. This would mean (if the stock price didn’t change) that the company would have a P/E ratio of only 10 in one year’s time ($40 divided by $4), making it appear very inexpensive.
The Bottom Line
The important thing to remember when looking at P/E ratios as part of your stock analysis is to consider what premium you are paying for a company’s earnings today and determine if the expected growth warrants the premium. Also, compare the company to its industry peers to see its relative valuation to determine whether the premium is worth the cost of the investment.
FAQs
In simple terms, a good P/E ratio is lower than the average P/E ratio, which is between 20–25. When looking at the P/E ratio alone, the lower it is, the better. For new investors, “P/E” might as well mean “physical education.”
Is a low PE stock always better than a high PE stock? ›
P/E ratio, or price-to-earnings ratio, is a quick way to see if a stock is undervalued or overvalued. And so generally speaking, the lower the P/E ratio is, the better it is for both the business and potential investors. The metric is the stock price of a company divided by its earnings per share.
Is a low PB ratio good? ›
Valuation Benchmark: A lower P/B ratio (typically below 1) can indicate that the stock is undervalued, suggesting that the market price is below the company's actual asset value. This can be an attractive opportunity for value investors looking for stocks with potential upside.
Is a negative PE ratio always bad? ›
It's possible for a stock to have a negative price-to-earnings (P/E) ratio. But it's not always a cause for concern. A company might be newly launched and not yet have accumulated earnings. Or a company might be on a path to growth.
Why do some companies have a low PE ratio? ›
A high P/E ratio might indicate that a stock's price is high relative to its earnings and potentially suggests that the stock is overvalued. On the other hand, a low P/E ratio might mean that a stock is undervalued.
Should you buy stocks with a low PE ratio? ›
Generally, a low P/E ratio is good
This is because you are spending less money for each dollar of a company's earnings.
What is the best PE ratio to buy a stock? ›
Average PE of Nifty in the last 20 years was around 20. * So PEs below 20 may provide good investment opportunities; lower the PE below 20, more attractive the investment potential.
Which is better, PE or PB ratio? ›
High PE can indicate high future growth expectations; low PE may suggest undervaluation. Low PB can suggest undervaluation, high PB may signal overvaluation or growth expectations. Can be influenced by non-operational factors and market sentiment. More stable, based on tangible book value of the company.
What PB ratio is overvalued? ›
In general, a P/B ratio below one indicates that a company is undervalued, while a ratio above one indicates that the company's stock is trading at a premium. However, what this tells you about a company varies between industries.
Why do banks have low PB ratios? ›
Bank stocks tend to trade at prices below their book value per share as the prices consider the increased risks from a bank's trading activities. The price-to-book (P/B) ratio can be used to compare a company's market cap to its book value.
How Much Income Puts You in the Top 1%, 5%, 10%? Stocks with high price-to-earnings (P/E) ratios can be overpriced. So, is a stock with a lower P/E ratio always a better investment than a stock with a higher one? The short answer is no.
What is the PE ratio of a Tesla? ›
PE Ratio Related Metrics
| PS Ratio | 8.295 |
|---|
| Earnings Yield | 1.57% |
| Market Cap | 724.00B |
| PEGY Ratio | 74.91 |
| Operating PE Ratio | 109.42 |
5 more rowsNo Correlation Between Earnings And Value
If accounting earnings actually drove valuations, then companies with high EPS growth should command higher multiples, and companies with low or negative EPS growth should have lower PE multiples. As Figure 1 shows, this correlation is nearly nonexistent.
What is the PE ratio of Apple? ›
P/E ratio as of September 2024 (TTM): 32.8
According to Apple's latest financial reports and stock price the company's current price-to-earnings ratio (TTM) is 32.8118. At the end of 2023 the company had a P/E ratio of 29.8.
What should be the pb ratio of stock to buy? ›
Conventionally, a PB ratio of below 1.0, is considered indicative of an undervalued stock. Some value investors and financial analysts also consider any value under 3.0 as a good PB ratio.
What is the PE ratio in layman's terms? ›
Key Takeaways. The price-to-earnings (P/E) ratio is the proportion of a company's share price to its earnings per share. A high P/E ratio could mean that a company's stock is overvalued or that investors expect high growth rates.
Do you want PE ratio to be high or low? ›
A higher PE suggests high expectations for future growth, perhaps because the company is small or is an a rapidly expanding market. For others, a low PE is preferred, since it suggests expectations are not too high and the company is more likely to outperform earnings forecasts.
What if stock PE is less than industry PE? ›
If a company's PE ratio is lower than its industry's average then it signifies that the company might be having more debt in the books relative to its peers or might be losing market share or might be having lower profit margins relative to its peers or there is some governance issues in the management.
Is 30 a good PE ratio? ›
A P/E of 30 is high by historical stock market standards. This type of valuation is usually placed on only the fastest-growing companies by investors in the company's early stages of growth. Once a company becomes more mature, it will grow more slowly and the P/E tends to decline.
