- P/E ratio is used to assess whether a stock price is overvalued or undervalued
- It indicates what the market is willing to pay for a stock today based on its past or future earnings
- P/E ratio is best used as a relative metric to compare against other companies operating in the same market/industry
- You will never need to work out the P/E ratio yourself - trading apps do that all for you!
Types of P/E ratio
There are two types of P/E ratios: forward P/E and trailing P/E. Let’s get into them…
- Forward P/E: Rather than trailing figures, forward P/E uses future earnings guidance to compare current earnings with future earnings. This is an important indicator of future performance and should therefore be the type of P/E used to make an assessment.
- Trailing P/E: More commonly used, trailing P/E relies on past performance metrics by dividing the current share price by the total EPS earnings over the past 12 months. This price to earnings ratio is more widely used, mainly because it isn’t based on predictions and projections, making it more objective than the forward P/E approach.
How to calculate P/E ratio
P/E ratio is calculated by dividing price per share by the company’s earnings per share.
But don’t worry – the actual number will always be stated on your trading platform. This means you will never need to work this out yourself – and that you certainly don’t need to be a maths wiz in order to be a successful investor.
What is a good price to earnings ratio?
Before we get into that, it’s important to note that a company’s price to earnings ratio is not useful alone: it is only useful when compared to the ratios of companies operating in the same market or industry. In that sense, P/E ratio is best used as a relative metric.
This is where things get a bit more complicated: P/E ratios generally vary from industry to industry. Typically speaking, the market average ratio ranges from 20 to 25 – 20 being good with high potential for earnings and 25 being overpriced. A high P/E ratio within that range suggests a stock's price is high relative to earnings and possibly overvalued. Conversely, a low P/E might indicate that the current stock price is low relative to earnings.
That being said, a P/E ratio of 10 could be pretty normal for a beverage company but exceptionally low for an automobile company. So if you’re assessing the P/E ratio of Carlsberg, for example, compare it to other beer companies on the market – this is how you’ll get the most accurate idea of what a P/E ratio should be within that industry.