The P/E ratio: what you pay for each dollar of earnings

The lesson in plain words

The same lesson as the slides above, written out in full.

1. The P/E Ratio

Welcome. The price to earnings ratio, universally called the P E, is arguably the most quoted number in all of investing. It answers a single question. How much are investors willing to pay for each dollar of a company's earnings? A P E of twenty means you are paying twenty dollars for every one dollar of annual profit. Whether that is cheap or expensive depends entirely on context, and that is exactly where most people go wrong. One note before we begin. This is financial education only, not financial advice.

• The P/E is arguably the most quoted number in investing.
• It answers one question: how much do investors pay for each dollar of earnings?
• Whether that is cheap or dear depends entirely on context.

A quick note: This is financial education only, not financial advice. Do not buy, sell, or hold anything based on this lesson.

2. Price Over Earnings

The formula is refreshingly simple. It is the share price divided by earnings per share. So if a stock trades at a hundred dollars and earned five dollars per share last year, its P E is twenty. Investors are paying twenty dollars for every one dollar of earnings. One way to picture it is years. At the current level of profit, you are paying about twenty years of earnings for the stock, which is why a high P E asks the future to deliver growth.

• The formula is simply share price divided by earnings per share.
• A $100 stock that earned $5 a share has a P/E of 20.
• That means investors are paying $20 for every $1 of earnings.
• It is a price, expressed in years of current profit.

3. Trailing versus Forward

There are two flavours of P E. Trailing P E uses the last four quarters of actual earnings, real numbers that have already been reported. Forward P E uses analyst estimates for the next twelve months, which are educated guesses. Neither is better, they simply answer different questions. Trailing tells you what happened, forward tells you what the market expects. If a company has a trailing P E of forty but a forward P E of eighteen, the market is expecting earnings to grow sharply, closing that gap.

• Trailing P/E uses the last four quarters of actual, reported earnings.
• Forward P/E uses analyst estimates for the next twelve months.
• Trailing tells you what happened; forward tells you what the market expects.
• A trailing 40 but forward 18 means earnings are expected to grow sharply.

4. What the Number Means

So how do you read the number? Below ten is either genuinely cheap, or the market sees serious trouble ahead, common in cyclical industries near a bottom. Ten to twenty is the broad range for mature, steady businesses, and the long run average for the S and P five hundred sits around fifteen to seventeen. Twenty to thirty five is growth premium territory, where the market expects above average growth. Above thirty five is either a high growth name whose earnings are expected to catch up, or a genuinely overvalued stock, and sometimes both. The one rule that matters most is this. Never compare P E ratios across different industries. A utility at twenty five times is expensive, a fast growing software company at twenty five might be cheap. Always compare within the same sector.

• Below 10: genuinely cheap, or the market sees trouble ahead.
• 10 to 20: mature, steady businesses; the S&P 500 long-run average is around 15 to 17.
• 20 to 35: a growth premium; the market expects above-average earnings growth.
• The critical rule: only compare P/Es within the same sector, never across industries.