What is the P/E ratio in stocks and why does it matter?

What exactly is the P/E ratio?

The P/E ratio is a straightforward metric investors use to quickly understand how ‘expensive’ (i.e., overvalued) or ‘affordable’ (i.e., undervalued) a stock is relative to the earnings the company generates. 

Imagine you're shopping for clothes. You see a shirt you like and you look at the price tag to decide if it's worth buying. If the shirt seems overpriced compared to its quality, you might pass on it. But if the price seems fair or even low compared to the quality you get, you're likely to buy it. Similarly, the P/E ratio helps you determine whether a stock’s price is justified based on the company's earnings.

This ratio is especially valuable for beginner investors because it cuts through complex financial data and provides a clear, simple number you can easily interpret.

How is the P/E ratio calculated?

Calculating the P/E ratio is straightforward and something anyone can easily do. Here’s a simple step-by-step guide:

1. Find the current price per share : Start by looking up the stock’s current market price. You can find this information on financial websites, investment apps, or even through a quick internet search.
   
2. Look up the earnings per share (EPS): EPS is usually listed in a company’s financial statements or annual report, available on the company's investor relations page or financial news websites. Earnings per share represent the company’s total profits for a twelve-month period, divided by the number of shares it has issued.
   
3. Divide the stock price by the EPS: Simply take the current stock price and divide it by the EPS you found earlier. This calculation will give you the P/E ratio.

Let’s walk through an example to make this crystal clear. Suppose a stock is currently trading at $100 per share, and the company’s EPS is $5. To calculate the P/E ratio, divide 100 by 5, which gives you 20. This means investors are paying $20 for each dollar of the company's earnings.

By performing this simple calculation, you can quickly determine if a stock’s price makes sense. A lower P/E ratio could mean the stock is undervalued or reasonably priced, suggesting a potential bargain. On the other hand, a higher P/E ratio might indicate the stock is overvalued unless the company is expected to grow significantly in the future. More on this below.

What does a high vs. low P/E ratio mean?

A high P/E ratio typically means investors expect the company’s profits to grow rapidly in the future. Investors feel comfortable paying more now because they believe the company will soon earn significantly higher profits. 

Companies in fast-growing sectors like technology often have high P/E ratios because investors anticipate things like continued innovation, expansion and increasing earnings. For example, tech giants like Apple or Amazon often have high P/E ratios because investors believe these companies will consistently deliver stronger earnings over time.

However, a high P/E ratio doesn’t always mean the stock is a guaranteed winner. Sometimes it can indicate that a stock has become overpriced due to market hype or speculation, even if the company’s actual financial performance doesn’t justify the high price. 

It's important to check if your assumptions are realistic by considering the company's financial health, its industry position, and broader economic factors.

A low P/E ratio usually signals one of two things. First, it could mean the stock is undervalued and potentially a great bargain, giving you an opportunity to buy quality stocks at a discount. Investors who hunt for value look for low P/E stocks because they believe the market hasn’t yet recognized the true worth of the company.

A low P/E ratio might also reflect investor concerns about the company’s growth prospects, such as slow earnings growth or industry challenges.

Established businesses in traditional industries like banking, utilities or consumer staples usually have lower P/E ratios because their earnings grow slowly but steadily, with fewer surprises. For instance, Walmart or Coca-Cola typically show lower P/E ratios due to their consistent (but modest) earnings growth.

To make the most of this information, it’s best to compare the P/E ratios of companies within the same industry. This enables you to spot which stocks offer better value and potential upside, without being misled by industry differences.

What's a good P/E ratio for stocks?

Determining a good P/E ratio for stocks depends largely on the specific industry and the individual company's situation. Generally speaking, a P/E ratio of about 15 or below often indicates that the stock might be undervalued, offering a potentially attractive buying opportunity. Stocks with P/E ratios over 25 could suggest the stock is overpriced unless there's strong expected growth in earnings to justify the higher price.

However, a good P/E ratio is not a one-size-fits-all figure. It varies significantly across different industries. For example, technology companies typically have higher P/E ratios because investors forecast rapid growth and increasing profits. Companies like Microsoft or Facebook often carry higher P/E ratios due to expectations of strong future earnings.

Utility companies or banks generally have lower P/E ratios. Their profits tend to grow at a slower and steadier pace, making them less attractive for investors looking for quick growth. Stocks like JPMorgan Chase or Duke Energy usually have P/E ratios that appear lower, reflecting their consistent yet steady growth.

When comparing stocks, it’s helpful to look at companies within the same industry, so you can clearly see if a P/E ratio makes sense for your investment goals. Comparing a high-growth technology company to a slow-growing utility firm can mislead your judgment. Within industries, you can look at historical averages to see how the current ratio stacks up over time, which can give you a clearer sense of whether a stock is cheap, fairly valued or overpriced based on its own historical range.

How you can use P/E ratios effectively in investing

To use P/E ratios effectively, follow these clear, practical steps:

1. Always compare stocks within the same industry
   Industries have different average P/E ratios. Technology companies typically have higher P/E ratios because they are assumed to grow quickly. In contrast, banks and utilities generally have lower P/E ratios due to more predictable and slower earnings growth.
   
2. Check historical P/E ratios for perspective
   Looking at a stock’s past P/E ratios can help you understand if it is currently ‘expensive’ or ‘cheap’ compared to its own history. A company consistently trading at a P/E ratio of 20 suddenly jumping to 30 could signal it has become ‘expensive’. Alternatively, a drop to a lower ratio might mean it's a good buying opportunity.
   
3. Consider future growth expectations
   Investors buy stocks based on future earnings projections. A high P/E ratio might be justified if a company is expected to grow rapidly, while a low P/E ratio could mean investors have modest assumptions for future growth. Always consider what analysts and market experts are forecasting.

The Crypto.com App provides intuitive analytical tools to simplify this process. These easy-to-use tools allow you to quickly analyze and compare P/E ratios across different stocks. Clear visuals, simplified data displays and interactive features help you quickly spot trends and patterns without needing deep financial expertise.

For example, our platform can show you a side-by-side comparison of companies within the same industry, helping you instantly see which ones have higher or lower P/E ratios. You can also view historical P/E data to see how the current ratio stacks up over time, making it easier to determine whether a stock is fairly valued or not.

Common misconceptions about the P/E ratio

• A higher P/E ratio is always better: While a higher P/E ratio can indicate optimism about future growth, it doesn’t automatically make the stock better. Sometimes, a high ratio just means the stock has become overpriced relative to its actual earnings.
  
• A negative P/E means the stock is undervalued: Actually, a negative P/E usually signals that the company is currently unprofitable. Instead of being undervalued, it might be facing financial difficulties.
  
• The P/E ratio includes dividends: The P/E ratio only accounts for a stock's price and its earnings per share. It doesn't factor in dividends, which are separate payments to shareholders.
  
• Stock splits affect the P/E ratio: Stock splits change the price per share and the total number of shares, but they don’t change the company's overall earnings or valuation. This means the P/E ratio remains the same after a stock split.

P/E ratio tips for beginners

• Combine the P/E ratio with other valuation tools, like price-to-book (P/B) or return on equity (ROE).
• Keep an eye on market trends that could influence earnings.
• Understand the broader economy. Economic growth, interest rates and industry trends can all impact the P/E ratio.
• Watch for sudden changes in the P/E ratio, as these might indicate important news or shifts in investor expectations.
• Consider market sentiment. Sometimes a stock can be undervalued or overvalued due to temporary emotions in the market.

Stocks with low and high P/E ratios: real-world examples

Stocks with low P/E ratios are typically found in stable, mature industries such as banking, utilities or consumer staples. Companies like ExxonMobil or JPMorgan Chase often have low P/E ratios because their earnings grow predictably but slowly. Investors who buy these stocks usually value consistency, regular dividends and reduced risk.

There are clear reasons behind these low ratios. Mature companies typically have fewer opportunities for rapid expansion and their steady business models rarely deliver surprises. This means investors have steady growth projections and are unwilling to pay high prices for their earnings.

In contrast, high P/E ratio stocks are common in sectors with strong growth potential, such as technology, biotechnology or emerging industries. Companies like Netflix, Amazon or Tesla frequently have high P/E ratios because investors believe their profits will significantly increase over time. 

High P/E ratios usually reflect strong investor optimism about future growth and profitability. However, they can also signal heightened risk, as investors are paying more today based on projections rather than current profits. If these expectations aren’t met, stock prices can decline rapidly.

Understanding why certain stocks have low or high P/E ratios helps you choose investments that align with your personal goals and risk tolerance. If you prefer steady, reliable returns, low P/E stocks might suit you best. If you’re comfortable with higher risks for potentially larger rewards, high P/E stocks might align better with your strategy.

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FAQs about the P/E ratio

Is a higher P/E ratio always better?
Not necessarily. A higher P/E ratio could mean that investors have high expectations for future growth, but it could also mean the stock is overpriced. It’s important to ask whether those expectations are realistic before jumping in.

Is a negative P/E ratio good or bad?
A negative P/E ratio is usually bad. It means the company isn't currently profitable, which often signals financial trouble or losses. It’s a red flag that should prompt a closer look at the company’s overall performance.

Does the P/E ratio use EBITDA?
No, it doesn't. The P/E ratio only considers net earnings per share, excluding EBITDA (earnings before interest, taxes, depreciation and amortization). If you want a broader view of company performance, you might want to look at other metrics that include operating income.

Are dividends included in the P/E ratio?
No, dividends aren't included. The P/E ratio only accounts for the stock's price and earnings per share. If you're investing for income, you’ll need to check dividend yield separately.

Does the P/E ratio change after a stock split?
No, stock splits don't affect the P/E ratio. Splits change the number of shares and the price per share, but the overall value and earnings stay the same, so the ratio remains unchanged.

Does a high P/E ratio mean I shouldn’t buy?
Not necessarily. A high P/E ratio can signal that investors forecast strong future growth from the company. If you believe the company has good potential to grow profits significantly, the higher price you're paying now might still be justified.

Should I avoid stocks with negative P/E ratios?
Usually, yes. A negative P/E ratio typically means the company is currently not profitable, which could signal financial instability or challenges in its business. Unless you have clear reasons to believe the company will soon become profitable, these stocks often carry higher risks.

Does the P/E ratio consider company debt?
No, the P/E ratio only accounts for the stock's current price and the company's earnings per share. To get a full picture of a company’s financial health, you'll also need to consider other metrics, such as the debt-to-equity ratio or how much debt the company carries relative to its overall finances.

Can the P/E ratio predict stock price movements?
Not directly. While the P/E ratio itself doesn’t predict stock prices, it does provide helpful clues about investor expectations and how the market values a company’s earnings. Used together with other financial indicators, it can help you spot potential trends or warning signs.

How frequently does the P/E ratio change?
The P/E ratio changes continuously throughout the trading day as stock prices move. It also changes whenever a company reports new earnings, which typically happens quarterly. Regularly monitoring these updates will help you maintain an accurate view of the stock’s valuation.

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