PE Ratio Definition and Importance in Stock Trading | Expert Insights (2024)

• A high PE ratio indicates the growth of the company or tells the traders that the stock is overpriced
• A low PE ratio could mean that the company is trading for less than its actual value
• Traders use PE ratio to compare different stocks
• There are three main ways to calculate PE ratio: Trailing Twelve Months (TTM) earnings, Forward earnings, and the Shiller P/E ratio
• As much as PE ratio analysis is important, it can also be misleading in certain cases

In simplest terms, the price-to-earning ratio or PE is a measurement that compares the stock's current price with its earnings per share (EPS). It shifts the focus from the price to the earnings, allowing the traders to make decisions based on a more accurate valuation.

The PE ratio indicates whether the stock is overpriced or undervalued in the market. A high PE ratio shows that the stock is overpriced i.e. it might not be worth the investment. If the stock has a low PE ratio, it is undervalued, i.e. it might yield generous profits in the future.

However, things are more complex in practice. If you only look at the PE ratio stocks definition and jump right into trading, you’ll likely lose a lot of money. Even simple measurements like this one have a number of important layers.

For example, a high PE also implies that a company is growing. In such cases, it’s better to look at past trends of the PE to understand whether a certain stock is worth the money or not.

Generally, a PE ratio analysis is a single piece of a large puzzle, but it still contains important information for investors and traders.

"Relative price earnings ratios move up because people expect either the industry or the company's prospects to be better relative to all other securities than they have been than their preceding view, and it can turn out to be justified or otherwise. Absolute price earnings ratios move up in respect to the earning power of the prospective earning power of that
is viewed by the investing public of future returns on equity and also in
response to changes in interest rates" - Warren Buffett

The meaning of PE for advanced stock traders

For advanced traders, the PE ratio can indicate the shifts in the shares. However, knowing the meaning of the PE ratio isn’t enough. Not only is it important to analyze the given PE ratio, but it’s also necessary to examine the circ*mstances that might have shifted the numbers.

For example, global events, such as the Covid pandemic, can mess up the PE ratio. During the initial stages of the pandemic, price-to-earnings ratios saw notable fluctuations. The PE ratios of the companies that already scored around 25, increased further to 40. In turn, the ratios for cheaper stocks experienced a decline.

In situations like this, seasoned traders should look past the PE ratio and concentrate on the reasons behind it.

The basic formula of the PE ratio is quite simple. It looks something like this:

PE Ratio = Market price per share ÷ Earnings per share

However, investors and traders usually want to calculate PE for a specific time. Depending on the period of their interest, they use one of the following three methods: The Shiller P/E Ratio, Trailing Twelve Months (TTM) Earnings, or Forward Earnings.

The Shiller P/E Ratio

The Shiller P/E Ratio estimates the value of the stock depending on the average earnings. To calculate the PE ratio with this method, you’d have to divide the price by the average earnings in the past 10 years and adjust it for inflation.

One of the most famous stock market indexes, the S&P 500 index, uses The Shiller P/E ratio to calculate the relation between price and earnings for a broader market.

TTM Earnings

Trailing Twelve Months (TTM) Earnings is a method that goes beyond the traditional price-to-earnings ratio definition. It calculates the PE ratio for the past twelve months, allowing traders to identify the patterns in stock prices.

Forward Earnings

Instead of focusing on the past, the Forward Earnings method calculates the ratio depending on the estimated earnings of the company. It’s helpful for investors who want to determine the value of the stock based on future earnings.

Pros of PE ratio

• Easy to calculate even for beginners
• Shows how much growth potential a certain stock has
• Enables traders to compare different stocks
• Indicates whether a stock is over or undervalued
• Sets the ground for more advanced analysis or future forecasts

Cons of PE ratio

• Doesn’t always reflect the full picture
• Doesn’t factor in accounting policies
• Can be subjective and limited
• Can be susceptible to manipulation from the companies
• Leaves ground for miscalculations during sudden rise/drop in earnings

PE ratio isn’t an accurate measurement for every company. In fact, it doesn’t apply to the majority of tech companies.

As we’ve already mentioned, a high PE ratio means that the stock is overpriced and, thus, it’s not worth purchasing at that specific moment. However, in some cases, PE also reflects the growth potential of the stocks.

For example, the PE ratio for Tesla is 204 at the moment. It’s quite a high number by all measurements. For comparison, the PE ratio for Amazon is around 51, for eBay, it’s 18, for PayPal it’s 32.

Tesla has a high PE ratio not because it’s overvalued in the market, but because of its growth potential. If we factor in anticipated technological developments, it’s not surprising that Tesla’s earnings are expected to grow.

In such cases, the traditional PA ratio meaning takes a slightly different turn.

PE ratio is important for stock traders as it lets them understand which stocks are worth the investment. It also helps them determine whether a stock is a value investment or a growth investment.

Value investment implies that the price of a stock on the market is lower than its actual worth. In other words, it means investing money in underpriced stocks. With the help of the PE ratio, traders can easily identify such stocks. If the price-to-earnings ratio is below the average, then they know the stock is underpriced.

As you’d remember from the price-earnings ratio explanation, underpriced stocks are quite attractive for traders and investors.

However, a low PE ratio could also indicate that the company is consistently losing earnings. In that case, it would be safer to stay away from that investment.

Growth investment means that the stock has a huge potential for growth, i.e. has a high forward PE ratio. Some traders prefer to opt for growth investments because they could essentially turn into significant profits. However, growth investment is way riskier compared to value investment.

Analyzing the PE ratio correctly is the key to success for stock traders. By factoring in the reasons behind the high or low PE ratio, they get the chance to better understand the value of the stock.

Most important features of the price-earnings (PE) ratio in the stock market

• Easily compares the stock prices between companies
• Simplifies stock trading analysis for beginners
• Delivers a unified measurement for many different industries
• Calculates the real value of the stock
• Uses accessible information for the valuation

PE ratio makes it easy to compare the stock prices of different companies. It’s advisable to select two stocks within the same industry for better analysis. For example, it’s always better to set two tech companies side by side. That way, their PE ratios will directly give you useful information.

Moreover, the PE ratio is quite easy to calculate, enabling beginners to take their first steps in stock trading. Complicated analysis can only baffle them and trigger poor decisions. Even though memorizing the “price-earnings ratio definition for dummies” won’t be enough, the PE ratio will certainly provide them with some core insights.

Additionally, the PE ratio unifies the measurement for all industries. Traders can easily collect PE ratios for different companies without having to make any modifications.

What’s more important is that the price-to-earnings ratio easily calculates the true value of the stock. It indicates how much people are willing to pay for $1 of earnings, making it easier to grasp the concept of stock prices.

Finally, the PE ratio uses information that is accessible to everyone. Traders can search the web and find the prices or earnings of the companies to calculate the ratio themselves. If not, they can use ready-made information available for the majority of stocks out there.

The PE ratio is one of the primary measurements of the stock market. Though it’s not perfect and has its share of cons, it certainly adds value to the analysis. It shows the investors which stocks are overpriced and which are undervalued. It also depicts the growth potential of the company by examining future earnings.

Traders usually use three methods to calculate the PE ratio: The Shiller P/E Ratio, Forward Earnings, and TTM Earnings. Each of these methods examines a different time period: the average of the past 10 years, earning predictions in the future, and earnings for the past 12 months.

Real-life cases and examples outside the price-to-earnings ratio definition show the pros and cons of this measurement. It’s not always objective and 100% accurate, but it is a solid benchmarking tool.

For beginners and seasoned traders alike, it’s advisable to dig deeper and figure out why PE ratios look the way they do.