What is the P/E Ratio? A Beginner’s Guide

How to use the P/E ratio when evaluating stocks, how to calculate it, and what to be cautious about

Dec 03, 2024

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👋🏼,

Hope you’re having a good week so far!

Here’s something that puzzled me when I first started investing:

Why do some companies have a share price that's just 5 times their earnings, while others are worth 50 times or more?

It’s not always obvious at first. Is it because one company is a bargain? Or is another just overhyped?

The answer lies in the price-to-earnings (P/E) ratio, which reflects how the market values a company’s current earnings and future potential.

The price-to-earnings (P/E) ratio tells a story - about a company’s growth potential, risk, and how the market views its future. But understanding why some stocks have low P/E ratios while others seem sky-high takes a little unpacking.

Today, I’ll break down:

What the P/E ratio really means
How the P/E ratio is calculated (with an example)
📹 Explainer
Low P/E and High P/E case studies 🤓
Is P/E ratio a good indicator for deciding which stocks to invest in?

Let’s jump in!

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P/E ratio in simple terms

The price-to-earnings (P/E) ratio measures a company's share price relative to its earnings per share (EPS).

Imagine you’re thinking about buying a share of a company - essentially a tiny slice of ownership in that business.

Naturally, you’d want to know if you’re getting a good deal, right?

That’s where the Price-to-Earnings (P/E) ratio comes in. It’s a handy number that gives you a sense of how much you’re paying for each dollar the company earns. Of course, it’s not the only factor to consider, but it’s a good starting point for figuring out if the price makes sense.

How is it calculated?

It's the price of one share of the company's stock divided by how much money the company makes per share, usually over a year.

Example

Imagine you're thinking about buying a share of a company for $20. And let's say that company makes $1 per share in profit every year.

To find the P/E ratio, you divide the price of the share ($20) by the earnings per share ($1). So, in this case, the PE ratio would be 20.

Now, what does that number mean?

If the P/E ratio is high, let’s say above 20 or 25, it means investors are willing to pay a lot for each dollar of earnings the company makes.

Maybe they think the company has a lot of potential for growth, or they're just excited about it for some reason.

But if the P/E ratio is low, typically below 15 or 10, it means investors aren't willing to pay much for each dollar of earnings. Perhaps they're worried about the company's future, or they think it's not doing so well at the moment.

So, when you're looking at the P/E ratio, you're basically trying to figure out if the company's stock is a good deal or if it's too expensive compared to how much money the company is making.

It’s like checking if a car you’re buying is priced fairly based on its features and mileage, or if it’s overpriced.

📹 Breakdown…

Earnings Multiple vs. P/E Ratio: What’s the Difference?

Here’s a common source of confusion: you might hear the term earnings multiple and wonder how it’s different from the P/E ratio.

Spoiler: it’s not. They’re essentially the same thing.

When people say "earnings multiple," they’re just using a different phrase to describe this concept.

For example, if a company’s stock price is $50 and its earnings per share (EPS) is $5, the P/E ratio is 10. That 10 is the earnings multiple, meaning people are paying 10 times the company’s annual earnings to own its stock.

Why the confusion?

It’s mostly in the language. "P/E ratio" is more technical, while "earnings multiple" sounds more casual or intuitive. But they both describe the same thing: how much you’re paying for every dollar the company earns.

So, if someone mentions an earnings multiple of 15, don’t overthink it - it’s just another way of saying the P/E ratio is 15.

Using P/E Ratio to Analyse a Stock

As a wise warrior on Reddit eloquently stated…

What’s crucial to remember is that a low P/E doesn’t automatically mean a good deal, and a high P/E doesn’t always mean a bad investment.

The key is looking at it in context.

If a company has a low P/E, ask yourself why.

Is it struggling?

Or is it just not in a sexy industry right now?

Let’s take an example of a company in this situation right now - Delta Airlines, as I write this, they’ve got P/E ratio of just over 8, which is v. low:

So the argument here, could be: with a low P/E ratio of 8.86, DAL 0.00%↑ (Delta Airlines) looks undervalued.

With strong earnings growth in Q4 and a healthy market cap of $41B, Delta, some would say, is a good a buy right now with favorable momentum and resilience.

But here’s the flip side: despite its low P/E ratio and earnings growth, Delta faces industry-wide challenges. Rising fuel costs, potential economic slowdowns, and geopolitical tensions could weigh on travel demand. Additionally, Delta’s $17 billion debt burden and vulnerability to external shocks, like the recent operational outage linked to CrowdStrike, highlight significant risks.

Likewise, if a company has a high P/E, dig into their growth potential.

Are they really growing that fast, or is the market overestimating their future?

Need we look further than to Nvidia NVDA 0.00%↑ as a case in point here - their current valuations drive painful levels of debate amongst investors. Is it overvalued or not seems to be anyone’s guess.

I want to be clear here - this isn’t about whether Delta or Nvidia are good buys. My point is to show how relying on P/E ratio alone can lead to some pretty bad decisions.

Is P/E ratio a good indicator for deciding which stocks to invest in?

Personally I think the P/E ratio has become misunderstood because many people keep insisting on using it as a shorthand metric to measure "cheap" or "expensive" stocks.

Yet this is impossible to derive from a P/E ratio alone.

The P/E ratio is just one piece of the puzzle, and it needs to be seen in context.

You’ve got to compare it to other companies in the same industry. And what’s considered “normal” varies - a P/E of 18 might be typical for one sector but low for another.

A high P/E doesn’t always mean a stock is overpriced. Some of today’s giants - like Apple, Amazon, and Meta had sky-high P/E ratios when they were growing like crazy, yet they turned out to be incredible investments.

At the same time, a low P/E can mean a company’s undervalued - or it might just reflect stalled growth or a lack of confidence in its future.

The key takeaway? P/E is a starting point, not the whole picture.

It’s most useful when paired with a broader analysis - digging into the fundamentals, like the balance sheet, cash flow, and income statements and understanding sector trends, customer sentiment etc.

Bottom line: if you hyper-focus on just the P/E ratio, you’re missing the forest for the trees.

Use it as part of a bigger toolkit for evaluating a company’s true value.

If you found this helpful, you’ll love my Stock Market Fundamentals Course!

It’s designed to guide you through the core aspects of the stock market and help you invest with confidence. Plus, as a FinBrain Pro member, you’ll also unlock access to my investment opportunity guides, practical investing resources, and more.

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