What is the Price to Earnings (P/E) Ratio?
The P/E ratio, or price-earnings ratio, is the ratio of a company’s share price or stock price to the company’s earnings per share, or EPS. This ratio is one of the simplest and most popular ways to value a company, and to determine whether a company’s share price is overvalued or undervalued.
- The P/E ratio is a quick and easy way for investors to determine whether a stock is overvalued or undervalued.
- The P/E differs from other market multiple ratios such as the P/B ratio, and P/S ratio, in that the P/E ratio only considers the stock price and earnings. The P/B ratio measures a company’s stock price relative to book value, and the P/S ratio takes into measures a company’s stock price relative to revenue.
- The P/E ratio, while simple and useful, is not a comprehensive and conclusive valuation ratio, because it does not account for a company’s growth prospects, nor does it consider whether or not the earnings are actually inflows or only earnings on paper.
- It is always helpful to assess a company’s P/E ratio by comparing it to key competitors or its industry sector, as well as a benchmark index such as the S&P 500.
Price to Earnings (P/E) Ratio Formula
The price to earnings ratio is calculated using the following formula:
P/E Ratio = Current Price Per Share / Earnings Per Share
- Current Price Per Share: The current price per share, also known as the market price, market price per share, share price, or current stock price. This is the most recent trading price for a given stock. The current price per share changes as investors buy or sell the stock, and changes constantly during the trading day.
- Earnings Per Share: Earnings per share, or EPS, is the value of earnings per a company’s outstanding shares. It is a very simple calculation – divide a company’s net income by their outstanding shares. It shows how much money a company makes per share of their stock. The EPS serves as an indicator of a company’s profitability – the higher the EPS, the more profitable the company.
How to Calculate the P/E Ratio Using the Current Price Per Share and Income Statement
It is impossible to calculate a company’s P/E ratio exclusively from the income statement because we still need to find the company’s current price per share. However, the company’s income statement still has valuable information we need – the earnings per share. In the event that a company’s income statement does not list its EPS, all income statements list the net income and shares outstanding, which we can then use to calculate the EPS.
Say we wanted to calculate the EPS for a company that is considered high growth – Salesforce (CRM). This is Salesforce’s income statement from the most recent quarter.
They make it easy for us- the income statement already lists their EPS as $2.85. This means that for every share of Saleforce’s stock, the company makes $2.85.
But let’s pretend that the income statement didn’t list this and we had to calculate Salesforce’s EPS ourselves. We would take their net income and divide it by their shares outstanding.
We would take their net income of $2.625B and divide it by their outstanding shares of 922 million. Once we do that, we get their EPS:
Salesforce EPS = $2,625,000,000 / 922,000,000 = $2.85
Now that we have their EPS, let’s see what their P/E ratio is as of right now.
According to Yahoo! Finance, Salesforce is currently trading at $252.38 a share. Now we can calculate the P/E ratio.
Salesforce P/E Ratio = $252.38 / $2.85 = 88.55
This P/E ratio is relatively high and indicates that Salesforce is currently trading at 88.55 times its earnings. This indicates that investors are willing to pay 88.55 times more than what Salesforce is earning per share. Many would consider this overvalued. Others would say that this is the price you have to pay for high future potential growth.
What is the Forward P/E Ratio?
We just calculated Salesforce’s trailing P/E ratio, or TTM (Trailing 12 months) P/E ratio. In other words, their P/E ratio based on past data. But say we wanted to calculate Salesforce’s Forward P/E ratio? This is a different version of the P/E ratio because it uses forecasted earnings for the P/E calculation.
According to Yahoo! Finance, Salesforce has a consensus projected EPS of $3.75 in 2021. If we divide the current stock price by this projected EPS, we get the following result:
Salesforce Forward P/E Ratio = $252.38 / $3.75 = 67.30
This tells us that in the coming year, we can expect Salesforce to trade with a 67.30 P/E ratio – a ratio slightly lower than today’s TTM P/E ratio. However, this number can be problematic for a number of reasons:
- Forward P/E ratio uses estimates, and consolidates a number from a variety of analysts, with potentially different motives.
- Forward P/E ratio may produce incorrect or biased results, and actual future earnings may prove to be different. While it’s always important to forecast and project a company’s performance, unforeseen events can happen that could radically change future earnings potential.
What is a Good P/E Ratio?
This is a difficult question to answer because there are simply so many things to consider when deciding if a P/E ratio is “good.” There is not necessarily one right or wrong answer when deciding if a P/E ratio is “good” or “bad.” Rather, it simply depends on your philosophy as an investor, and how you measure a stock’s P/E ratio to its industry competitors and the broader S&P index.
The P/E ratio is not a liquidity ratio, profitability ratio or risk ratio. Rather, it is a market multiple ratio. It simply shows how much money people are willing to pay for a stock today based on its past or future EPS. If one is a value investor, a high P/E may illustrate a stock with unacceptable risk. A high P/E could mean that a stock is overvalued, and its price is too high relative to its earnings.
A growth investor, however, may not care about this – they may be willing to pay 88.55 times earnings for a stock such as Salesforce because they like their growth prospects. On the other hand, a low P/E ratio will attract value investors because they may find that they are trading at a significant discount relative to their earnings.
Furthermore, when assessing a technology company P/E ratio, it should be compared to 5 of its top industry competitors and the tech heavy NASDAQ first. As previously calculated, Salesforce’s TTM P/E ratio is 88.55 while its forward P/E ratio is 67.30. Let’s see how that stacks up to some of its competitors as of October 1, 2020:
|Stock/Index||P/E Ratio (TTM)||P/E Ratio (Fwd)|
|SAP SE (SAP)||34.29||24.27|
One can interpret this a few ways. On one hand Salesforce is trading at a considerably higher P/E multiple than its competitors as well as the broader tech index of the NASDAQ. This can be interpreted in one of two ways. Salesforce is a younger and growing company compared to more established players in the field such as Microsoft and Oracle, and investors are willing to pay a higher multiple due to that growth potential. Or, Salesforce is simply overvalued, and is trading at an overly high valuation – especially when you compare it to the broader tech index. The “correct” answer depends in many ways on your view of a company’s future prospects.
Investors can gauge a stock’s P/E ratio by comparing it to the broader overall market as well. A good way to do this is with the S&P 500. Because the S&P has such a wide variety of stocks in different sectors, comparing the S&P’s current P/E ratio to its historic P/E ratio, and then comparing a stock’s P/E ratio to the S&P’s ratio, is a good way to assess the value. Below is the P/E ratio of the S&P 500 over the last 20 years.
As we can see from the chart, the average P/E for the S&P 500 has hovered around 20 over the last 20 years. However, notice the P/E ratio during the dotcom bubble in the early 2000s, and the P/E ratio during the 2008 financial crisis. It was at nearly 50 at the turn of the millennium, and at nearly 120 during the height of the financial crisis.
Today, during the COVID induced recession, the S&P’s P/E is around 26-27. While this isn’t as high as the P/E ratio of the dotcom bubble and financial crisis, it still indicates a market that is trading at a considerably higher multiple than average, and could very well be overvalued. Comparing Salesforce’s P/E ratio to the S&P’s may give one a better interpretation of whether or not it is trading at that level due to growth prospects or if it is simply overinflated.
All of the following reasons might lead to some issues when interpreting the P/E ratio:
- Not Always Reliable For Companies With Negative Earnings: The P/E ratio is not always reliable when it comes to evaluating companies that have either negative earnings or considerable debt.
- Subjective Interpretation: This is not a ratio based off of the actual balance sheet of a company, it is not based exclusively off their income statement, and it is not an indicator of cash flow. Rather, this is simply showing how much investors are willing to pay for a stock. Investors, depending on their philosophy of growth vs. value may find a P/E ratio either good or bad, with no right or wrong answer.
- Comparability Can Lead to Misleading Interpretations: Like any other ratio, when evaluating the P/E ratio of a company, it must be compared to direct competitors, as well as the broader index. Certain industries will have different ratios, and a lot of it is based on market sentiment rather than actual fundamentals.
- Does Not Tell The Full Story: While the P/E ratio does a good job as a simple way to decide if a company is undervalued or overvalued, it does not account for a company’s growth prospects, nor does it consider whether or not the earnings are actually inflows or only earnings on paper. While the Forward P/E ratio does this to a degree, it is largely not reliable as it relies on analyst projections rather than actual earnings.
Comparing P/E Ratios of Salesforce (CRM) and CBRE (CBRE)
To see how to understand the P/E ratio in practice, consider the P/E ratios (TTM) of a high-flying tech stock like Salesforce (CRM) and a commercial real estate stock such as CBRE Group (CBRE). Both are in very different fields and are very different stocks. CRM is a pure growth stock, while CBRE is the quintessential dividend paying real estate stock.
Over the last 8 years, notice how much higher Salesforce’s P/E ratio is than CBRE. Not only that, notice how much more Salesforce’s P/E fluctuated compared to CBRE. This indicates a stock that has considerably more price swings than CBRE, and a stock that investors are willing to pay a higher multiple for just for its growth prospects. While Salesforce’s P/E ratio today is 88.55, CBRE’s is just 13.51. Salesforce has also had a return of over 1600% since 2008, while CBRE has had a return of around 125%.
Price to Earnings Ratio vs. Price to Book Ratio
We will first compare the P/E ratio to the P/B ratio, or the Price-to-Book ratio.
The P/B ratio is calculated using the following formula:
P/B Ratio = Current Price Per Share / Book Value Per Share
- Book Value Per Share: The Book Value Per Share takes a company’s common equity and divides it by its number of shares outstanding. This value indicates a company’s net asset value (total assets – total liabilities) on a per-share basis.
This ratio is strongly preferred by value investors, because it offers a more tangible valuation of a company than the PE ratio. However, while the P/B ratio gives investors a better idea of the types of assets behind a certain stock, it does not work well for all industries. While this ratio works well for asset heavy sectors such as financials, stocks such as Salesforce do not necessarily need many assets in the normal course of their business. Therefore, it can be hard to answer which ratio is better – P/E or P/B. It largely depends on the stock and industry being analyzed. While often both ratios are important to analyze together in order to take an accurate picture of a company’s value and financial health, this is not always the case.
Price to Earnings Ratio vs. Price to Sales Ratio
The next comparison is with the P/S ratio, or the Price-to-Sales ratio.
The Price to Sales ratio is calculated using the following formula:
P/S Ratio = Current Price Per Share / Sales Per Share
- Sales Per Share: The sales per share per share is the amount of revenue a company makes per outstanding share. It is calculated by dividing a company’s revenue from a specific reporting period – either quarterly or annually – by the total number of shares outstanding during that same period.
While the P/S ratio is advantageous in that you can still calculate it even if companies are currently operating at a loss, this ratio, compared to the other two, is more easily manipulated and misleading. The P/S ratio is typically more useful when comparing high growth companies with no profits or companies within the same industry.
Simply put, this is not a comprehensive ratio. Depending on how profitable a company really is, their sales could be worth a little or a lot when it comes to the bottom line. For example, a company could be making billions in sales, yet lose money on every transaction – but the P/S ratio would be unable to provide any insight into this.
P/E Ratio vs P/B Ratio vs P/S Ratio
|P/E Ratio |
Current Price Per Share/Earnings Per Share
|Easy to calculate and readily available.|
Quick and easy benchmark for investors to value of a stock, and compare with competitors and indexes
|TTM is based on past data, forward is based on unreliable and possibly untrustworthy projections.|
Not comprehensive, and does not take into account debt, cash flow, or negative earnings.
|P/B Ratio |
Current Price Per Share/Book Value Per Share
|The best for conservative investors-offers a more tangible valuation of a company than their earnings.|
Best ratio to give investors an idea of the types of assets behind certain stocks.
|Not helpful when evaluating companies with few assets such as tech companies. |
Can be especially difficult when comparing or evaluating companies that adhere to different accounting standards – i.e. international companies.
|P/S Ratio |
Current Price Per Share/Sales Per Share
|Quick and easy snapshot in comparing companies within the same industry. |
Can still calculate it even if a company is not profitable
|Does not consider company profitability. |
Does not explain the true worth of a company’s sales. A company can make billions in sales yet lose money on every transaction.
Drawbacks to Market Multiple Ratios
While market multiple ratios are a good way to take a snapshot of a company’s valuation, there are several serious flaws and drawbacks to consider before putting too much stock and emphasis into these ratios.
- Difficult to Compare Companies in Different Sectors: Like any other ratio, market multiple ratios are only truly effective and comprehensive when comparing companies within the same industry. Different companies in different industries have different growth prospects, different balance sheets, different income statements, and different revenue streams. How can we compare the Price to Book ratio between JP Morgan and Salesforce for example, when JP Morgan has countless assets and Salesforce doesn’t? What is the point in comparing JP Morgan and Salesforce’s Price to Sales ratio, for example, when one company makes their money off of interest payments and the other company makes their money off of enterprise technology services? These ratios only tell part of the story and must be used in conjunction with other metrics to truly evaluate a given stock.
- Overly Simplifies Complex Information: While making these ratios so simple can be advantageous in that it gives investors a quick snapshot into a company’s value, the oversimplification has serious drawbacks as well. By simplifying complex information into just a single ratio, other factors that can influence a company’s performance are effectively ignored and disregarded.
- Only Accounts for Past Data: While the Forward P/E ratio is based off of future projections, they are not always reliable or trustworthy. For the most part, these market multiple ratios only consider a company’s finances from the past and at a certain point in time, and neglect to include a company’s growth prospects or future business operations.
- Not Adjusted for Different Accounting Practices: Ratios such as the P/B ratio are not good when comparing companies with different accounting practices- namely international companies. Even if a company like Salesforce and SAP have similar business operations, they may have vastly different accounting policies. After all, one company is American, and the other is German. The multiples may be easily misinterpreted as a result, with inconclusive comparisons.