The Price/Earnings Ratio (P/E) is a valuation ratio where a company's current share price is divided by its per-share earnings.
P/E Ratio is one of the most widely watched measures of valuation for both the stock market as a whole and for individual stocks. It is sometimes referred to as the "multiple," because it shows how much investors are willing to pay per dollar of earnings. If a company is trading at a P/E of 15, an investor would be paying $15 for $1 of earnings.
P/E for a public company
P/E is a valuation ratio of a company's current share price compared to its per-share earnings. The ratio is calculated as:
- Market Value Per Share / Earnings Per Share (EPS)
- Market Value Per Share / Earnings Per Share (EPS)
For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).
EPS is usually from the last four quarters (Trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (Projected or Forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.
The price-earnings ratio is also sometimes known as "price multiple" or "earnings multiple".
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.
The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.
It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number. The use of (GAAP) reported earnings vs the use of (non-GAAP) operating earnings is also a common source of confusion.
P/E for a fund or an index
There are multiple ways to compute the P/E of a fund (or an index) as a composite of individual companies' earnings and market values. The following describes distinct methodologies for TTM (Trailing Twelve Months) P/Es. It is important to only compare P/E values computed with the same methodology. There is no consensus on which approach is better. [note 1]
Standard & Poor's (S&P) computes the S&P 500 TTM P/E by dividing the current index price by the sum of the TTM earnings (positive or negative) of all constituents. To have a more manageable number for the index level, the sum of the earnings is divided by a fixed scale factor called the divisor . In other words, the P/E of the index is directly proportional to the aggregate market capitalization divided by the aggregate earnings. The State Street SPDR funds display TTM P/E for the indices they track (e.g. S&P), based on a weighted harmonic average computation, which is mathematically equivalent to the S&P methodology.
Vanguard provides a TTM P/E metric on the Web pages describing its funds, using the following methodology . First, the P/E of each constituent is determined, based on price and TTM earnings. Then a weighted harmonic average of such individual P/Es is computed, associating a weight to each constituent proportional to its market value relative to the aggregate market value of the fund. Using a harmonic average presents the advantage of reducing the effect of outliers (e.g. companies with very small earnings, hence a high P/E). Companies with negative earnings were included in the computation until May 2017 (like S&P does). Starting from June 2017, Vanguard aligned its methodology with Morningstar and now excludes companies with negative earnings from the computation .
Morningstar performs a computation similar to Vanguard, while applying a filter to individual P/Es . Negative values are eliminated (and corresponding companies not included in the aggregate market value). Then the weighted harmonic average is computed. Note that this TTM P/E metric isn't directly accessible via the Morningstar Web pages, which display a Forward P/E (based on analysts estimates) instead of a Trailing (TTM) P/E. Ycharts.com does provide the Morningstar TTM P/E metric for funds, referring to it as "Weighted Average PE Ratio".
Robert Shiller has developed a stock valuation metric known as "PE10"; alternatively called CAPE (Cyclically Adjusted Price Earnings) ratio, or Shiller PE ratio. It is a variation of P/E, but with EPS (Earnings Per Share) averaged over the prior 10 years. Both terms (Price and Earnings) have to be expressed in real terms, i.e. adjusted for inflation.
Note that Prof. Shiller uses the same methodology as Standard & Poor's (S&P) to compute the 'Price' and 'Earnings' components of the equation (i.e. simple aggregate).
- Multiple pros and cons articles are mentioned in this forum discussion: Morningstar and P/E TTM: what a wonderful world!.
- "Price/Earnings Ratio (P/E)". Fidelity Investments. https://www.fidelity.com/learning-center/trading-investing/technical-analysis/technical-indicator-guide/pe-ratio.
- Inside the S&P 500: PE and Earnings Per Share
- Why ETF Price/Earnings Ratios Lie
- MSCI Methodology for Calculating Fundamental Data Ratios at Index Level, May 2006
- Vanguard doesn't provide a methodology document. The description was obtained in an exchange with Vanguard support.
- Vanguard changed their way of computing PE ratios
- Average Price Ratios: Morningstar Methodology Paper (2005)
- Online Data - Robert Shiller