You’ve probably heard financial analysts advise that a stock is overbought or oversold, or that it has a high or low valuation. But what exactly does that mean? The concept underlying those assessments is the price-to-earnings ratio (P/E), and understanding it can provide insight into whether a stock is being traded at a price that is proportionate to its worth. The P/E ratio is the baseline of all stock analysis, from the lowest gut hunches to the most complicated algorithms.
Simply put, the P/E ratio quantifies the relationship between two things: how much a company is earning on a per-share basis, and how much investors are willing to pay for each dollar of those earnings. The ratio is easy to calculate: You take the current price of a stock and divide it by the earnings per share (EPS) over the last four quarters. For instance, Coca-Cola (KO) earned $1.60 per share in the 2014 fiscal year and the stock was recently trading at about $41.52. Dividing the latter by the former, we see that KO was trading at a P/E of just under 26.
Is that high or low? The answer depends on who you’re asking and what you’re comparing it against. Often P/E ratios are compared within a market sector, such as consumer staples. Other times they are compared against the average of an index such as the S&P 500. Understanding the factors that affect a P/E can help investors better arrive at portfolio holdings that meet their tolerance for risk and fit into their overall investment strategy.
One thing to understand right off the bat is that the more a company is expected to grow its earnings in the future, the higher its P/E ratio will be. That is why Facebook (FB) has a P/E ratio of nearly 80 while Exxon Mobil (XOM) has a P/E ratio of only 13. Some might argue that Facebook shares do not deserve a valuation that is 6 times higher than Exxon Mobil, but the market sends a message with this rich valuation that it believes Facebook will grow its earnings sharply in the future.
Historical P/E Ratios
It’s not just individual stocks that have P/E ratios. Even the S&P 500, one of the broadest market indexes, has a P/E ratio of its own. That P/E compares the price of the index to the total earnings of the 500 companies within it, and it was recently close to 21. Interestingly, this number can be extremely volatile and varies widely with both macro factors affecting the economy and micro factors that affect the individual companies within the index.
Over the trailing 140 years of its history, the average P/E of the S&P 500 is about 16, with the most frequent P/E levels ranging from 10 to 20. And over the past 5 years, as our stock indexes have been steadily rising, P/E ratios have continued to creep higher. That leads some people to think that stock prices are overvalued, while others believe the market is expressing heightened expectations for future earnings growth.
What It Means for Your Investment Strategy
Understanding the P/E ratio can inform your decisions about what to include and exclude from your portfolio. For example, knowing that a given stock trades at nearly 80 times its trailing earnings might help you determine whether you want to own that stock. Perhaps you believe strongly in the company and are willing to buy the stock at that valuation because you believe that at some point in the future, the company will earn 10 times more than it does today.
On the other hand, evaluating a P/E ratio may help you realize that you prefer to buy the value side of the market, which typically consists of stocks and indexes with more modest P/E ratios. Warren Buffet is one of the most famous value-oriented investors, and is known for buying stocks with margins of safety, often in the form of low P/E ratios.
Of course, the P/E ratio is only one factor of many that an investor may consider when building an investment portfolio. The P/E ratio is easy to identify and widely discussed, so it’s a good number to understand. At the very least, it can provide you with a jumping-off point for analyzing a stock, sector, or broad market index.
 This represents the trailing P/E ratio. Forward P/E ratios would be devised using the estimates for the upcoming four quarters.