"Is it expensive?" is one of the first questions people ask about a stock. The most common answer is the P/E ratio. It's useful, but only if you know what it does and doesn't tell you.
What P/E means
P/E = share price ÷ earnings per share.
If a stock costs $100 and the company earned $5 per share over the last year, the P/E is 20. Put simply: you're paying $20 for every $1 of yearly profit.
- A higher P/E means investors are paying more for each dollar of today's profit, usually because they expect profits to grow.
- A lower P/E means they're paying less, often because they expect slower growth, more risk, or trouble ahead.
Trailing vs forward P/E
- Trailing P/E uses the last 12 months of actual earnings.
- Forward P/E uses analysts' estimates for the next 12 months.
Forward P/E is often lower for growing companies, because expected earnings are higher. Remember that forward earnings are forecasts, and forecasts change (see estimate revisions).
Why "low P/E" isn't automatically cheap
- The market may be right. A low P/E can mean profits are expected to fall. If earnings halve, a P/E of 8 becomes a P/E of 16 at the same price.
- One-off earnings distort it. A big one-time gain makes P/E look low; a one-time charge makes it look high.
- Cyclical companies trick you. Steelmakers and chip-equipment makers often show their lowest P/E at the peak of the cycle, just before profits drop.
- No profit, no P/E. Companies losing money don't have a meaningful P/E at all.
Compare it with the right things
A P/E means little on its own. Compare it with:
- The company's own history. Is it high or low compared with its usual range?
- Similar companies. Software and utilities trade at very different P/Es for good reasons.
- Its growth. A P/E of 30 with profits growing 30% a year can be cheaper than a P/E of 12 with shrinking profits. Some people use the PEG ratio (P/E divided by the growth rate) as a rough shortcut.
A few other numbers that help
- Price to sales (P/S): useful when profits are small or negative.
- Free cash flow yield: free cash flow per share divided by the price, i.e. how much cash the business produces for each dollar you pay.
- EV/EBITDA: like P/E, but counts the company's debt, which P/E ignores.
- Debt: two companies with the same P/E can carry very different risk if one has far more debt.
Valuation and timing
Valuation is a poor timing tool. Expensive stocks can stay expensive for years, and cheap ones can stay cheap. Valuation matters most over the long run, which is why it says much more about where a stock might be in a few years than about next week.
How Ticker Council uses valuation
The Financials seat on Ticker Council reads revenue, margins, growth, the balance sheet, free cash flow and valuation multiples compared with the company's sector. Its lean counts for little over the next week and most over the next year, because valuation and growth decide where a stock ends up over time, not in a few days. You can see how it voted, and what the rest of the Council thought, on any stock's run, or on public stock pages such as NVDA.
Not financial advice: this guide explains valuation measures, not what to buy or sell.
Questions
What is a good P/E ratio?
There isn't one number. Compare a stock's P/E with its own history, with similar companies and with how fast its profits are growing. A high P/E can be fair for a fast grower; a low one can be a warning for a shrinking business.
What is the difference between trailing and forward P/E?
Trailing P/E divides the price by the last 12 months of actual earnings. Forward P/E uses analysts' estimates for the next 12 months, which are forecasts and can change.
Does a low P/E mean a stock is undervalued?
Not necessarily. It can mean investors expect profits to fall, or that one-off gains inflated recent earnings. Check why the P/E is low before treating it as a bargain.