What is a Stock Worth?

If you’re an investor researching different options for your portfolio, you have likely come across the phrase price-to-earnings (P/E) ratio. While it may sound like financial jargon at first, grasping the significance of the P/E ratio can be a game-changer for investors as it can help guide your decisions and provide insight into a company's valuation and what a stock is worth.

Let's dive into what the P/E ratio is and why it matters for investors.

What is the P/E Ratio?

The P/E ratio is a fundamental metric used to evaluate a company's current share price relative to its per-share earnings.¹ It's calculated by dividing the current market price of a stock by its earnings per share (EPS). The resulting P/E ratio gives investors an idea of how much they pay for a company's earnings. The formula is:

P/E Ratio = Market Price per Share / Earnings per Share (EPS)

Market Price per Share is the current price at which the stock is trading on the market. Earnings per Share (EPS) represents a company's net income divided by the number of outstanding shares. P/E ratio is a quick way to see if a stock is undervalued or overvalued. And so generally speaking, the lower the P/E ratio is, the better it is for both the business and potential investors. You shouldn’t compare P/E ratios of different kinds of companies, like a tech company and a consumer staple company. In other words, the metric is only useful when comparing apples to apples.²

Types of P/E Ratios

There are two types of P/E ratios: trailing P/E ratios and forward P/E ratios.

A trailing P/E ratio is based on past earnings and is calculated using a company's actual reported earnings over the last 12 months (LTM). It's a historical measure of valuation.³

Forward P/E uses estimated future earnings instead of past earnings. Analysts often provide these estimates, and they are based on forecasts for the next 12 months. This ratio gives insight into market expectations and growth prospects.⁴

Why Does the P/E Ratio Matter?

P/E ratios matter when considering your investments for a number of reasons, including the following:

Valuation Comparison

One of the primary reasons the P/E ratio is important is because it can help you compare the valuations of different companies within the same industry.⁵ The economic theory provides an understanding that expected returns are driven by the prices investors pay and the cash flows they expect to receive. The valuation equation tells us that stocks with a lower relative price (“value” stocks), a smaller market capitalization, and higher profitability have higher expected returns than stocks with a higher relative price (“growth” stocks), larger market capitalization, and lower profitability.⁶

Growth Expectations

The P/E ratio can also offer insights into market expectations for a company's future growth prospects. A high P/E ratio may indicate that investors are optimistic about the company's growth potential. Conversely, a low P/E ratio could indicate a bargain, but it may also be a sign of a struggling company.

Risk Assessment

Understanding a company's P/E ratio is essential for risk assessment. A very high P/E ratio may suggest that the stock is overvalued, meaning there's a risk of a price correction if the company fails to meet growth expectations. Conversely, a low P/E ratio could signify skepticism or a lack of confidence in future growth.

Market Trends and Sentiment

Over time, changes in a company's P/E ratio can reflect broader market trends and sentiment. If a company's P/E ratio increases significantly, it could indicate growing investor confidence and a bullish market. On the other hand, a decreasing P/E ratio may signal a bearish market or concerns about the company's future performance.

The price-to-earnings (P/E) ratio is an important metric in investing. It offers a snapshot of a company's valuation, growth expectations, and market sentiment. By understanding the P/E ratio and its importance, investors can make better informed decisions.