The price-to-earnings ratio, also known as P/E Ratio, P/E, or PER, compares the price of a company’s stock with the earnings it generates. Investors use it to assess the potential value of a stock. If a stock’s price is high relative to its earnings, it may be overvalued. If a stock’s price is low relative to its earnings that may be a sign its being undervalued by the market. 

Understanding the P/E Ratio and how to use it, can help you make more informed investment decisions and build a strong portfolio.

Arriving at the P/E Ratio is quite straightforward. You simply divide the market value or price per share by the company's earnings per share.

Formula:

Let's say the price per share is $30 and the earnings per share are $1.5.

The earnings per share (EPS) can be calculated by dividing the company's net earnings available to common shareholders by weighted average shares outstanding over a certain period of time. Typically, the last twelve months are taken into consideration. 

Formula:

EPS = (Net Income – Preferred Dividend) / Weighted Average Shares Outstanding 

Shares outstanding is the total number of shares owned by investors as well as restricted shares held by employees and company officials. The number of outstanding shares of a company may change at various times during the year. Several events such as new share issues, the exercise of stock options, conversion, and cancellations through buybacks may change this number.

It's worth noting that the P/E Ratio of a stock isn’t particularly helpful when viewed in isolation. To gain valuable insight, you need to compare it against the stock’s historical P/E or a competitor’s P/E.

This ratio accounts for a company's actual earnings. The Trailing P/E Ratio is calculated across a period of previous quarters. If the company in question has reported their earnings accurately, the trailing P/E Ratio can offer a more precise valuation. It should, however, not be used as an indicator of future performance.

Formula:

The Forward P/E Ratio is calculated by estimating the net earnings of upcoming or future quarters. It is essentially the company's best estimate of future earnings and can be found in the earnings release by the company or from analysts’ estimates. As an investor, you can compare current earnings to future earnings and hopefully get a clearer picture of what growth may look like. However, this metric can be problematic as analysts could underestimate or overstate the estimated future earnings.

Formula:

While the P/E Ratio is a helpful metric, it does have certain limitations. You can address these limitations by using other metrics like earnings yield and the price/earnings to growth ratio, or PEG.

The P/E Ratio can’t be used to assess the potential value of companies that produce zero or negative earnings such as high-tech, high-growth and start-up companies. That’s where the earnings yield comes in. The earnings yield is the opposite of the P/E Ratio. It’s calculated by dividing a stock’s earnings per share by its price and is expressed as a percentage. If you’re trying to assess the potential rate of return provided by stocks offered by companies with zero or negative income, use the earnings yield instead. 

In addition, P/E Ratios may not be the best way to assess a company’s potential growth rate, even when using a forward earnings estimate. Investors often use the price/earnings-growth ratio, or PEG to address this. The PEG Ratio compares a company’s P/E Ratio with its earnings growth rate over a given period. By considering a company’s earnings and future growth rate, the PEG Ratio is seen to provide a better assessment of a stock’s future value. While a low P/E Ratio may suggest a stock is undervalued, considering its growth rate may show that the company’s earnings are improving. The PEG Ratio is also a better metric to use when comparing companies operating in different industries.

In summary, while the P/E Ratio is a useful metric, it can’t tell you the whole story. Income-focused investors should also consider a company’s earning yield to understand the potential earnings provided by a given investment relative to its price. Growth-focused investors should also consider the PEG Ratio to gain a better understanding of a company’s valuation and expected earnings growth.

What constitutes a good P/E Ratio varies among industries, market conditions and company performance. Lower P/E Ratios can sometimes be a sign that a stock is undervalued relative to its earnings. 

A better way to tell if a stock has a good P/E Ratio is to compare it against industry averages and growth expectations. Average P/E Ratios generally range from 20 to 25. While the lower a P/E Ratio is, the better, any P/E Ratio below this average is generally considered acceptable.

A higher P/E ratio than the industry average suggests that investors expect higher earnings growth than those with a lower P/E and can imply that the stock is overvalued. However, a higher PE ratio can also be attributed to high growth prospects. If a company is expected to grow rapidly, investors might be willing to pay more for its earnings.

Companies with negative earnings will have a negative P/E Ratio. If a company’s total net income over the past 12 months is negative, their EPS will be negative as well. Negative P/E Ratios over the short-term may not necessarily mean that a company is in trouble. This can be particularly true for high-tech, high-growth and start-up companies that experienced losses because they invested heavily in growth and development. However, if a company has posted a negative P/E Ratio over a number of years, that can be a sign the company is in danger. 

There are many financial ratios that are used in fundamental analysis that can help you determine a more accurate value of a company’s stock. Several investors use the P/E ratio as part of the research process, as it helps them figure out if they are paying a fair price for a stock. However, the P/E Ratio should not be the only metric you use to make an investment decision. It is important to consider a variety of other ratios in your research process for more informed decision making.