What is the Price-to-Earnings (P/E) Ratio?
The P/E ratio measures a company's current stock price relative to its earnings per share (EPS). It shows how much investors pay per dollar of earnings.
Formula:
P/E = Market Price per Share ÷ Earnings Per Share (EPS)
A high P/E suggests investors expect strong future growth (or possible overvaluation). A low P/E indicates undervaluation, slow growth, or risks.
Variations of the P/E Ratio
The P/E isn't a single metric — it comes in several flavors:
| Variation | Description | Key Characteristics |
|---|---|---|
| Trailing P/E | Uses actual EPS from the past 12 months (or last four quarters) | Backward-looking, based on reported historical data; more reliable as it's factual |
| Forward P/E | Uses analyst-estimated EPS for the next 12 months | Forward-looking, reflects growth expectations; can be optimistic or inaccurate due to forecast biases |
| CAPE (Shiller P/E) | Uses average inflation-adjusted earnings over the past 10 years | Smooths out short-term fluctuations; often used for long-term market valuation |
| PEG Ratio | P/E divided by the expected earnings growth rate (%) | Adjusts P/E for growth; a PEG near 1 is often seen as fair value |
Who First Came Up with It?
No single inventor exists, but Benjamin Graham and David Dodd popularized the P/E ratio in their 1934 book Security Analysis, making it a cornerstone of value investing.
Earlier academic work existed, with studies on the "P/E effect" dating back to at least the 1960s (e.g., S.F. Nicholson in 1960).
Who Uses It the Most?
The P/E ratio is one of the most widely used metrics among investors. A Bank of America survey found that nearly 80% of investors rely on the forward P/E as a key factor in decision-making, making it the top valuation metric.
Value investors (e.g., followers of Graham or Warren Buffett) use it extensively to identify undervalued stocks.
Trailing P/E vs Forward P/E
Trailing P/E relies on historical, reported earnings. It provides a factual view of past performance but doesn't account for future changes.
Forward P/E relies on analyst projections. It's often lower than trailing if strong growth is expected, but it's less reliable due to potential optimism or errors in forecasts.
If forward P/E is significantly lower than trailing, it signals expected earnings growth.
What Is It Used For?
Investors mainly use the P/E ratio to:
- Assess valuation — is a stock overvalued or undervalued relative to peers, industry averages, or its own history?
- Gauge expectations — what does the market expect for future growth?
- Compare companies — within the same sector, P/E provides a quick relative measure.
- Screen opportunities — low P/E for bargains, high P/E for growth stocks.
It's a quick gauge of "how expensive" a stock is relative to earnings.
When Is It Telling a Story (Insightful)?
The P/E is most reliable and informative in these conditions:
| Condition | Why It Works |
|---|---|
| Mature companies | Stable industries with consistent earnings make comparisons meaningful |
| Predictable earnings | Not distorted by temporary factors or accounting noise |
| Combined with other metrics | Used alongside growth rate (PEG), debt levels, or cash flow |
| Similar company comparisons | Same sector, similar business models, comparable size |
| Historical context | Compared against the company's own historical P/E range |
When Is It Lying (Misleading)?
The P/E can deceive in several predictable situations:
| Situation | Why P/E Misleads |
|---|---|
| Cyclical companies | Earnings fluctuate with cycles — a low P/E at peak earnings may signal overvaluation ahead |
| One-time events | Non-recurring gains/losses distort EPS (e.g., asset sales or write-offs) |
| High-growth tech stocks | High P/E reflects future potential, but if growth falters, it crashes |
| Negative earnings | P/E becomes meaningless or negative |
| Accounting differences | Companies use varying methods, making cross-comparisons flawed |
| Ignores other factors | Debt, cash flow, capital structure — a low P/E with high debt may hide risks |
Existing Research
Academic studies extensively document the P/E ratio:
| Finding | Source | Implication |
|---|---|---|
| Value premium | Nicholson (1960), Basu (1977) | Low P/E stocks historically outperform high P/E stocks over the long term |
| Predictive power | Robert Shiller | High aggregate market P/E (or CAPE) often signals lower future returns |
| Forward vs Trailing | Multiple studies | Trailing P/E often performs better for value selection due to biases in analyst forecasts |
| High P/E interpretation | Recent research | High P/E more often reflects lower expected future returns than exceptionally high growth |
| Additional factors | Various | Earnings quality and investor sentiment also influence P/E reliability |
Bottom line from research: P/E is useful but not infallible — best when used with other tools.
The Bottom Line
The P/E ratio earned its popularity for good reason — it's simple, intuitive, and widely available. But simplicity comes with blind spots.
Use P/E as a starting point, not a verdict. Combine it with growth rates (PEG), cash flow metrics (P/FCF), and sector-specific multiples. And always ask: what's driving the E in P/E?
The best investors don't just calculate the ratio. They understand what's behind it.