By CFO Brew Staff
less than 3 min read
Definition:
The price-to-earnings (P/E) ratio is a common and important metric that investors use to analyze the value of a company. Specifically, the P/E ratio helps them determine whether a company is overvalued or undervalued. Investors will compare P/E ratios of one firm with others in its industry or market. Companies with incredibly high P/E ratios may not be able to justify their value through their current or future earnings.
Here’s what to know about the P/E ratio.
- It’s calculated simply by dividing the market value per share (stock price) by earnings per share, or EPS. The resulting number theoretically reflects how many years it would take share purchasers to get their money’s worth. What about a company that’s recording losses (or, negative earnings)? They typically have an undefined or “not applicable” P/E ratio.
- Experts often consider a P/E ratio between 20 and 25 as average, although this may vary by industry or how the market is doing overall. A lower than average P/E ratio can indicate a company is undervalued, and therefore a good investment, while a high P/E ratio may signal that investors expect more robust earnings growth from that company compared to its peers.
- There are additional wrinkles to the P/E ratio. A forward P/E ratio is calculated with a company’s projected future earnings, while a trailing P/E ratio is the “standard” form of the ratio, according to Investopedia, and it uses recent earnings in its calculation.
