A P/E (price-to-earnings) ratio is a metric that compares a company’s share price to its annual net profits. This ratio can be used to compare companies of similar size and industry to help determine which company is a better investment. A P/E ratio is also an important metric to help determine the future profitability and growth of a company.
In this guide, we’ll go over:
- What Is the P/E Ratio Used For?
- How to Calculate P/E Ratios
- Example of a P/E Ratio Calculation
- How to Show P/E Ratio Knowledge on Your Resume
- Related Investing Skills
What Is the P/E Ratio Used For?
The P/E ratio, also called the earnings multiple, is a business valuation technique that helps investors determine if a company is over- or under-valued. Financial metrics, like P/E ratios, that look at a company’s earnings are important because they can help guide investing and investment banking decisions and inform whether a company is profitable or will be profitable.
The price-to-earnings ratio can be used to compare a company to its competitors in the same industry. Comparing different companies’ P/E ratios can determine which is a better investment. However, the P/E ratio can also be compared to the company’s past performance to get a better idea of how the company has grown and predict how it may grow over time.
Many careers in finance use price-to-earnings ratios when looking at potential investments. Investment bankers and investors rely on this ratio to gain insight into a company’s financial health and potential growth.
What Is a Good P/E Ratio?
There is no such thing as a good or bad ratio. Ultimately, the ratio is relative: A ratio is either high or low only when compared to other companies in the same industry or to the company’s past performance. The ratio needs context to provide value.
However, high or low earnings-per-share ratios can signify certain things about the company or the investment:
- A high ratio means the stock is overvalued. However, a high ratio often signifies that it is a growth stock, meaning there is a chance of high future performance, even if the cost per share is high at the moment. However, growth stocks are also volatile, meaning they can be risky investments.
- A low ratio means the stock is undervalued. This means that while the company is doing well growth- and profits-wise, the stock price is below par, making it a bargain for investors.
How to Calculate P/E Ratios
There are two main types of P/E ratio analysis:
A trailing P/E analysis divides the cost per share by the company’s past 12 months of earnings (often referred to as the trailing twelve months or TTM). This method is the most commonly used approach because the data is objective — as long as the company has reported its earnings correctly and honestly, a trailing P/E ratio uses only concrete data, rather than subjective or projected data.
However, because past earnings are only reported every quarter, and stock prices can change daily as the market evolves, the trailing P/E ratio will constantly change.
A forward P/E analysis uses forecasted earnings — how much a company expects to earn in the future. Forward P/E ratios are useful because a company’s past data is not always indicative of future performance.
However, a forward P/E relies heavily on estimations from analysts and the company itself. A company may over or underestimate its future earnings as a way to toy with its P/E ratios and drive changes in investor behavior.
>>MORE: What Is an Investor?
P/E Ratio Formula
The main formula used to calculate a company’s trailing P/E ratio is:
P/E Ratio = Cost per Share / Earnings per Share
In this formula:
- Cost per share is the current trading price of a stock or how much it costs to buy one share in the company.
- Earnings per share (EPS) is how much net profit the company sees each year, divided by the total number of outstanding shares (shares of common stock issued to investors). In a trailing P/E analysis, the earnings per share is based on the previous 12 months of earnings, while a future P/E analysis looks at projected earnings from analysts and the company itself.
A company’s P/E ratio will be shown in a “#x” type of format (such as 20x or 15x) — this signifies how many times higher the stock price is compared to the earnings per share.
Example of a P/E Ratio Calculation
If a company’s stock is trading at $30 for one share, and the company’s annual earnings per share is $1, then that company’s P/E ratio is 30/1 or 30x. All that really tells us is that for every $30 stock, the company earns $1 per year.
Or, to look at it another way, if the stock price and earnings stay constant, it would take 30 years for the company to have enough profit to recoup the share price.
P/E Ratio in Practice
To truly understand the value of a company’s P/E ratio, it needs to be compared to another company. Let’s look at the following table:
|Company A||Company B||Industry Average|
|Cost per Share||$30||$20|
|Earnings per Share||$1||$0.50|
Because Company B is cheaper per share, it is tempting to assume it is a better deal than Company A. However, Company A is cheaper because you are paying less for every $1 of earnings per year. Especially if we take into consideration that the industry average for these companies is 30x, Company A is the more “on par” investment — it is well-priced compared to most companies in the industry.
Company B is overvalued. This could indicate that investors are expecting high future growth for that company, but the investment is riskier overall.
>>LEARN MORE: Gain more investing skills with JPMorgan’s Investment Banking Virtual Experience Program.
How to Show P/E Ratio Knowledge on Your Resume
If you have previous work or internship experience related to investing or investment management, it is likely understood that you can use and calculate P/E ratios. Price-to-earnings ratios are listed on every stock chart. They are also a core factor to consider when investing in the stock market. Ultimately, any work or internship experience that involves investing will inherently include an understanding of P/E ratios.
However, if you have no professional experience using P/E ratios, but you do have experience in buying stocks, you can convey your understanding by discussing any personal trading experience in your cover letter. For example, if you bought a few shares of Twitter in 2018, and manage your personal investment portfolio (no matter how small), your cover letter is a great space to talk about it!
>>MORE: Learn other ways to showcase hard skills.
Related Investing Skills
Understanding how to calculate a price-to-earnings ratio is vital for investment bankers and professional investors. If you want to increase your investing knowledge, some skills you should know are:
- How to calculate a discounted cash flow (DCF) valuation. This determines how well a company can generate future returns on investments.
- How to read a stock chart to understand a company’s market capitalization, price per share, and dividend yield.
- How to calculate a company’s compound annual growth rate (CAGR) This determines how well an investment has performed historically, or how well it may perform in the future.
Start expanding your investing skills today with Forage’s Investment Banking Skills Passport.