# Price to earnings

## Quick definition

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Updated: Jan 8, 2024

Price to earnings is a ratio that divides a company stock’s current price by its earnings per share to determine the company’s relative valuation.

## Key details

• The price to earnings ratio is the most popular company stock analysis by which investors evaluate a company’s relative value
• By dividing a company stock’s current price by its earnings per share, investors can use price to earnings to determine if a stock is undervalued or overvalued
• Price to earnings also serves as a comparison point for a stock against other stocks either in the same industry or the broader market

## What is price to earnings?

Price to earnings is a ratio used as an analysis by investors to determine a stock’s relative value. The ratio divides a company stock’s current price by its earnings per share to establish a value that can be used to assess whether a stock is undervalued or overvalued at its current price. Investors can use this information to gauge the right timing to invest in a stock of interest.

A way of looking at price to earnings is to see it as a means of standardising the value of \$1 of earnings in the market. This is because the ratio indicates the amount in dollars that an investor can expect to invest into a stock, in order to gain \$1 of that company’s earnings. A high ratio would indicate that a stock is overpriced as investors are willing to pay over \$1 for \$1 of earnings, whereas a low ratio would indicate that a stock is underpriced as investors are willing to pay lower than \$1 for \$1 of earnings.

A stock can also be compared against other stocks in the same industry and/or the broader market using the value derived from its price to earnings. This information enables productive insight. Investors can use this information to determine if they should buy the stock or consider the company’s competitors in the industry and/or market instead.

### How is price to earnings calculated?

The price to earnings metric is calculated as a way of ascertaining whether the prevailing share price accurately represents the company’s projected earnings per share. The metric is calculated by simply dividing the market value per share and earnings per share.

P/E = Market value per share / Earnings per share

## What is forward P/E?

Forward P/E is a type of price to earnings ratio that uses future earnings guidance instead of the most recent quarter. Often referred to as estimated price to earnings, the ratio seeks to compare the current earnings to future earnings. Value investors rely on a forward price to earnings metric to see what earnings could look like in the future.

One of the biggest drawbacks of forward P/E is that companies sometimes use the opportunity to underestimate earnings as a way of ensuring they beat analysts’ earnings estimates. Some companies overestimate their earnings as a way of getting a higher valuation in the market, then adjust it going into the earnings estimate.

## What is trailing P/E?

The trailing Price to Earnings Ratio is a financial metric that provides a historical record of a company’s performance. The metric is calculated by dividing the current share price with the earnings over the past 12 months.

Unlike Forward P/E, this metric tends to be more popular as it is objective, given the use of actual numbers and not estimates. However it also has its fair share of drawbacks. For starters, past earnings might not act as a good indicator of how a company is likely to perform in the future, especially if there are changes in the market cycle and economic cycles.

In addition, value investors maintain that investors should invest capital based on companies’ future earnings power. The fact that earnings remain constant amidst fluctuating share price can also make the trailing P/E unreliable.

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Financial Writer
Srijani was a Financial Writer for Invezz covering stocks, investment funds, securities, and commodities. She is UK law-qualified and has worked in both the legal industry... read more.