It’s handy for comparing a company’s valuation against its historical performance, against other firms within its industry, or the overall market. EPS is a financial metric used to measure a company’s profitability on a per-share basis. It is calculated by dividing the company’s net income (after taxes and preferred dividends) by the number of outstanding shares of common stock. The PEG (price/earnings growth) ratio takes into account not only a stock’s P/E ratio but also its expected earnings growth. PEG can give investors a more comprehensive take on a stock’s potential and whether it’s undervalued or overvalued compared to companies in the same industry with similar growth prospects.
A P/E ratio of N/A means the ratio is unavailable for that company’s stock. A company can have a P/E ratio of N/A if it’s newly listed on the stock exchange and has not yet reported earnings, such as with an initial public offering. One limitation of the P/E ratio is that it is difficult to compare companies across industries.
Alternatives to P/E Ratios
They are only one tool used to conduct analysis, and taken alone, they could create a misleading picture. If you’re new to investing, there’s no better way to get started than by checking out our guide to the best stock trading platforms for beginners. I’d also encourage new investors to practice first by making trades using a paper trading account.
- Investors often use the EV/EBITDA ratio to evaluate companies in capital-intensive industries such as telecommunications or utilities.
- Investors typically compare the EPS of two or more companies within the same industry to get a sense of how one company is performing relative to its peers.
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- Then divide that amount by the average number of outstanding common shares.
The price–earnings ratio, also known as P/E ratio, P/E, or PER, is the ratio of a company’s share (stock) price to the company’s earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued. A P/E ratio of 15 means that the company’s current market value equals 15 times its annual earnings. Put literally, if you were to hypothetically buy 100% of the company’s shares, it would take 15 years for you to earn back fringepay your initial investment through the company’s ongoing profits.
When combined with EPS, the P/E ratio helps gauge if the market price accurately reflects the company’s earnings (or earnings potential). The market price of the shares issued by a company tells you how much investors are currently willing to pay for ownership of the shares. The PEG ratio tends to be most useful when examining companies in high-growth industries, where P/E ratios alone might appear to be on the higher side. A PEG ratio of 1 or less usually indicates that a stock may be undervalued or trading at fair value based on its growth potential. This provides a snapshot of how willing investors have been to buy the stock based on real performance during the past year. The limitation is that future growth prospects could change, and trailing P/E does not consider this.
Shareholders might be misled if the windfall is included in the numerator of the EPS equation, so it is excluded. Sometimes an adjustment to the numerator is required when calculating a fully diluted EPS. For example, sometimes a lender will provide a loan that allows them to convert the debt into shares under certain conditions. To better illustrate the effects of additional securities on per-share earnings, companies also report the diluted EPS, which assumes that all shares that could be outstanding have been issued.
For example, in February 2024, the Communications Services Select Sector Index had a P/E of 17.60, while it was 29.72 for the Technology Select Sector Index. To get a general idea of whether a particular P/E ratio is high or low, compare it to the average P/E of others in its sector, then other sectors and the market. The inverse of the P/E ratio is the earnings yield (which can be thought of as the earnings/price ratio). The earnings yield is the EPS divided by the stock price, expressed as a percentage. However, there are problems with the forward P/E metric—namely, companies could underestimate earnings to beat the estimated P/E when the next quarter’s earnings arrive.
P/E vs. Earnings Yield
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However, it should be used with other financial measures since it doesn’t account for future growth prospects, debt levels, or industry-specific factors. The price/earnings (P/E) ratio, also known as an “earnings multiple,” is one of the most popular valuation measures used by investors and analysts. The basic definition of a P/E ratio is stock price divided by earnings per share (EPS). The ratio construction makes the P/E calculation particularly useful for valuation purposes, but it’s tough to use intuitively when evaluating potential returns, especially across different instruments. Another critical limitation of price-to-earnings ratios lies within the formula for calculating P/E. P/E ratios rely on accurately presenting the market value of shares and earnings per share estimates.
Another alternative is the price-to-sales (P/S) ratio which compares a company’s stock price to its revenues. This ratio is useful for evaluating companies that may not be profitable yet or are in industries with volatile earnings. Although earnings growth rates can vary among different sectors, a stock with a PEG of less than one is typically considered undervalued because its price is low relative to its expected earnings growth. A PEG greater than one might be considered overvalued because it suggests the stock price is too high relative to the company’s expected earnings growth. Investors often base their purchases on potential earnings, not historical performance.
Diluted Earnings Per Share Calculation (EPS)
One of the simplest and most common ways to evaluate a stock involves looking at its price-to-earnings ratio (P/E ratio). This ratio provides insight into a company’s current stock price in relation to its earnings. With a closing price of $18.22, it had a dividend yield of 11.68% and was trading at a P/E of 8.25 (for an earnings yield of 12.12%). With the dividend yield just below the earnings yield, the dividend payout ratio was 96%. The earnings per share figure is especially meaningful when investors look at both historical and future EPS figures for the same company, or when they compare EPS for companies within the same industry. To calculate earnings per share, take a company’s net income and subtract preferred dividends.
A Variable in the Price/Earning Ratio
The P/E ratio is one of many fundamental financial metrics for evaluating a company. It’s calculated by dividing the current market price of a stock by its earnings per share. It indicates investor expectations, helping to determine if a stock is overvalued or undervalued relative to its earnings. The P/E ratio helps compare companies within the same industry, like an insurance company to an insurance company or telecom to telecom.
High P/E ratios must also be interpreted within the context of the entire industry. Adjusted EPS is a type of EPS calculation in which the analyst makes adjustments to the numerator. Typically, this consists of adding or removing components of net income that are deemed to be non-recurring. However, assume that this company closed 100 stores over that period and ended the year with 400 stores. An analyst will want to know what the EPS was for just the 400 stores the company plans to continue with into the next period.
As well, if the projections are accurate, it can give investors an insight into stocks that are likely to soon experience growth. As such, when looking at the stock of a particular company, it is more useful to evaluate the P/E ratio of that company against the industry average rather than the market average. EPS also does not take into account the price of the share, so it has little to say about whether a company’s stock is over or undervalued.