What is the Price to Earnings (PE) ratio?

What is the Price to Earnings (PE) ratio and how can it be used to help investors analyse what they should pay for a stock?

a woman

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Ah! The famous "Price to earnings ratio". This is viewed as the ultimate measure by most as to what a stock is actually worth.

The PE ratio is simply the price of a stock relative to its earnings per share. This is a common metric used by investors to analyse what they should pay for a stock. It is used as a measure to interpret how much money a firm is currently earning relative to its valuation and how much the company expects to earn in the future, relative to what the business is expected
to be worth.

For traditional "value investors" companies which had high PE ratios are generally viewed as being expensive, while those with lower ratio's often provide greater levels of value. Firms which have a high price to earnings ratio are generally considered to:

  • Have above average business prospects and potentially in a phase of rapid expansion/growth.
  • Have the ability to generate significant amounts of free cash flow (money) on an ongoing basis.
  • Have captured high levels of investor confidence and demonstrate an ongoing sustainability to their business. This potentially includes companies who aggressively repurchase their own shares or have paid increasing dividends on a yearly basis.
  • Be positioned in a highly favourable industry which may have above average business prospects, such as e-commerce or technology.

On the other hand firms which have a low price to earnings ratio are considered:

  • To have below average growth prospects and may potentially experience contractions in their business.
  • To be unable to generate excess funds for their shareholders, potentially being forced to reinvest all of their earnings in the business to sustain their operations.
  • Have very low levels of investor confidence. This includes firms which have potentially missed their earnings forecasts on several occasions and have potentially cut their dividend payments.
  • Be positioned in an industry which is considered to be highly unfavourable for business, such as the aviation industry or heavy industrials.

Forward Price to Earnings Ratio & Yield

The price to earnings ratio is calculated on a forward basis, particularly for firms which are experiencing rapid levels of growth. For example, a firm which has a current price to earnings to ratio of 30 and is growing earnings at 40% per annum is generally considered to be highly undervalued as its current earnings will grow significantly. On the other hand, a firm which has a price to earnings of 15 and stagnant earnings is often considered to be fairly valued.

A firm's price to earnings ratio is one important metric used in valuation. It is particularly useful when utilizing the future prospects of the firm. Remember that a company's PE ratio depends entirely on the state of the business, so you may often wind up with exactly what you paid for!

Motley Fool contributor Marcello Pinto has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

More on ⏸️ Investing

A white and black robot in the form of a human being stands in front of a green graphic holding a laptop and discussing robotics and automation ASX shares
Technology Shares

Joining the revolution: How I'd invest in ASX AI shares right now

Advances in artificial intelligence (AI) could usher in a new industrial revolution. Here’s how you can invest in it.

Read more »

Close up of baby looking puzzled
Retail Shares

What has happened to the Baby Bunting (ASX:BBN) share price this year?

It's been a volatile year so far for the Aussie nursery retailer. We take a closer look

Read more »

woman holds sign saying 'we need change' at climate change protest
ETFs

3 ASX ETFs that invest in companies fighting climate change

If you want to shift some of your investments into more ethical companies, exchange-traded funds can offer a good option

Read more »

a jewellery store attendant stands at a cabinet displaying opulent necklaces and earrings featuring diamonds and precious stones.
⏸️ Investing

The Michael Hill (ASX: MHJ) share price poised for growth

Investors will be keeping an eye on the Michael Hill International Limited (ASX: MHJ) share price today. The keen interest…

Read more »

ASX shares buy unstoppable asx share price represented by man in superman cape pointing skyward
⏸️ Investing

The Atomos (ASX:AMS) share price is up 15% in a week

The Atomos (ASX: AMS) share price has surged 15% this week. Let's look at what's ahead as the company build…

Read more »

Two people in suits arm wrestle on a black and white chess board.
Retail Shares

How does the Temple & Webster (ASX:TPW) share price stack up against Nick Scali (ASX:NCK)?

How does the Temple & Webster (ASX: TPW) share price stack up against rival furniture retailer Nick Scali Limited (ASX:…

Read more »

A medical researcher works on a bichip, indicating share price movement in ASX tech companies
Healthcare Shares

The Aroa (ASX:ARX) share price has surged 60% since its IPO

The Aroa (ASX:ARX) share price has surged 60% since the Polynovo (ASX: PNV) competitor listed on the ASX in July.…

Read more »

asx investor daydreaming about US shares
⏸️ How to Invest

How to buy US shares from Australia right now

If you have been wondering how to buy US shares from Australia to gain exposure from the highly topical market,…

Read more »