Using the Price to Earnings Ratio and PEG to Assess a Stock (2024)

Theprice-to-earnings ratio(P/E)is one of the most widely used metrics for investors and analysts to determinestock valuation. It shows whether acompany's stock price is overvalued or undervalued and can reveal how astock's valuation compares to its industry group or a benchmark like the S&P 500 index. A good P/E for one group or sector could be a poor P/E for another sector so comparisons should compare similar companies.

The P/E ratio helps investors determinethe market value of a stock as compared to the company's earnings. It shows what the market is willing to pay for a stock based on its past or future earnings.

What Is a P/E Ratio?

Companies that grow faster than average, such as technology companies, typically have higher P/Es. Ahigher P/E ratio showsthat investors are willing to pay a higher share price now due to growth expectations in the future.The median P/E for the S&P 500 was 14.93 as of May 2023.

Investors not only usethe P/E ratio to determine astock's market valuebut also in determiningfutureearnings growth. Investors might expect the company toincrease its dividendsas a result if earnings areexpected to rise. Higher earnings and rising dividendstypically leadto a higher stock price.

Formula and Calculation of the P/E Ratio

The P/E ratio is calculated by dividing the stock's current price by its latest earnings per share: Current price / most recent earnings per share = P/E ratio.

Earnings per share (EPS) is the amount of a company's profit allocated to each outstanding share of a company'scommonstock. It serves as an indicator of the company’s financial health. Earnings per share is the portion of a company's net income that would be earned per share if all profits were paid out to its shareholders.EPS is typically used by analysts and traders to establish the financial strength of a company. EPS providesthe “E” or earnings portionof the P/E valuation ratio.

Analyzing P/E Ratios

A stock should be compared to other stocks in its sector or industry group to determine whetherit's overvaluedorundervalued. Similar companies should be compared to each other, like insurance to insurance or oil producer to oil producer.

An industry group will benefit during a particular phase of thebusiness cycle in most cases, so many professional investors will concentrate on an industry group when their turn in the cycle is up. Remember that the P/E is a measure of expected earnings. Inflationtends to rise as economies mature. The Federal Reserveincreases interestrates as a result of slowing theeconomyandtaming inflation to prevent a rapid rise in prices.

Certain industries do well in this environment. Banks earn more income as interestrates rise because they can charge higher rates on their creditproducts, such as credit cards and mortgages. Basic materials and energy companies also receive a boost in earnings frominflation because they can charge higher prices for the commodities they harvest.

Interest rates will typicallybe low and banks tend to earn less revenue toward the end of an economic recession. But consumercyclical stocksoften havehigher earnings because consumers may be more willing to purchase on credit when rates arelow.

Limitations to the P/E Ratio

The first part of the P/E equation orpriceis straightforward because the current market price of a stock is easily obtained, but determining an appropriate earnings number can be more difficult. Investors must determinehow to define earnings and the factors that impact earnings. There are some limitations to the P/E ratio as a result as certain factors impact the P/E of a company.

Volatile Market Prices

Volatile market prices can throw off the P/E ratio, but this more commonly happens in the short term.

Earnings Makeup of a Company

The earnings makeup of a company is often difficult to determine. The P/E is typicallycalculated by measuring historical earnings or trailing earnings, but historical earningsaren't of much use to investors because they reveal little about future earnings.

Forward earnings orfuture earningsare based on the opinions ofWall Streetanalysts, and they can be overly optimistic in their assumptions during periods of economic expansion. They can be overly pessimistic during times ofeconomic contraction.

One-time adjustments such as thesale of a subsidiarycould inflateearnings in the short term. This complicates the predictions of future earnings because the influx of cash from the salewouldn't be a sustainable contributor to earnings in the longterm.Forward earnings can be useful, but they're prone to inaccuracies.

Earnings Growth

Earnings growth isn't included in the P/E ratio.The biggest limitation of the P/E ratio is that ittells investors littleabout the company's EPS growth prospects. An investor mightbe comfortable buying in ata high P/E ratio expecting earningsgrowth tobring the P/E back down to a lower level if the company is growing quickly. But they might look elsewherefor a stock with a lower P/E if earnings aren't growing quickly enough.

It can be difficult to tell if a high P/E multiple is the result of expected growth or if the stock is simply overvalued.

The PEG Ratio

A P/E ratio doesn't always show whether the P/E is appropriate fora company's forecasted growth rate even when it's calculated using a forwardearnings estimate. Investorsturn to another ratio known as thePEG ratio to address this limitation.

The PEG ratio allows investorsto calculate whether a stock's priceisovervalued or undervaluedby analyzing bothtoday's earnings and the expectedgrowth rate for the company in the future.

Example of a PEG Ratio

An advantage of using the PEG ratio is that you can compare the relativevaluationsof different industries that may have very different prevailing P/E ratios. This facilitates the comparison of different industries that each tend to each have their own historical P/E ranges. Here's a comparison of the relative valuation of a biotech stock and an integrated oil company.