What is a P/E ratio?
The P/E ratio, or price to earnings ratio, is a stock's price divided by the company's yearly profit per share. It tells you how many dollars investors are paying for each dollar of the company's earnings.
A simple example
A company earns 2 dollars of profit per share over the past year, and its stock costs 40 dollars. Its P/E is 40 divided by 2, which is 20. You are paying 20 dollars for each dollar of yearly profit.
High or low
A high P/E usually means investors expect profits to grow fast. A low P/E can mean a bargain, or it can mean investors expect trouble. Compare a company with its own history and with similar companies, not with businesses in very different industries.
Two versions
Trailing P/E uses profits from the past 12 months. Forward P/E uses analysts' estimates for the next 12 months, which may turn out wrong.
Limits
P/E does not work when a company has no profit. One-time gains or losses can make it look too low or too high for a year. For companies whose profits swing with the economy, P/E can look lowest just before profits fall. That is why some investors use a longer average, like the Shiller CAPE.
Frequently asked questions
What is a good P/E ratio?
There is no single good number. It depends on how fast the company grows, how steady its profits are, and what similar companies trade at.
Is a low P/E always cheap?
No. A low P/E can be a warning that profits are expected to fall. Value investors check why a stock looks cheap before buying.
What is the earnings yield?
It is the P/E flipped upside down. A P/E of 20 means an earnings yield of 5 percent, which some investors compare with bond rates.