Have you ever wondered how investors decide if a stock is expensive or a good deal? One of the most common tools they use is something called the “price to earnings ratio,” or P/E ratio for short. Let’s break down what this number means, why people pay attention to it, and whether it should matter to you as an investor.

What Is the P/E Ratio?

The price to earnings ratio is actually a simple math formula:

P/E Ratio = Stock Price ÷ Earnings Per Share

Let’s use a real example to make this clear. Imagine a company called “Super Sneakers” that has a stock price of $50. Last year, they earned $5 for each share of stock they have. To find their P/E ratio:

$50 ÷ $5 = 10

This means Super Sneakers has a P/E ratio of 10. Investors often say the stock “trades at 10 times earnings” or has a “multiple of 10.”

What Does the P/E Ratio Tell Us?

At its most basic, the P/E ratio tells us how much investors are willing to pay for each dollar of a company’s earnings. In our example:

• Investors are willing to pay $10 for every $1 that Super Sneakers earns
• Another way to think about it: If nothing changes with the company’s earnings, it would take 10 years of earnings to equal the price you paid for the stock

Generally speaking:

• A higher P/E ratio suggests investors expect the company to grow its earnings in the future
• A lower P/E ratio might mean investors are less optimistic about future growth, or that the stock might be undervalued

Why Do Investors Care About P/E Ratios?

Investors pay attention to P/E ratios for several important reasons:

1. Comparing Different Companies

Let’s say you’re trying to decide between buying stock in two different shoe companies:

• Super Sneakers: $50 stock price, $5 earnings per share, P/E ratio of 10
• Amazing Athletics: $100 stock price, $5 earnings per share, P/E ratio of 20

Even though Amazing Athletics has a higher stock price, what really matters is that you’re paying twice as much for each dollar of earnings. This doesn’t automatically mean Super Sneakers is a better investment, but it does tell you that investors have higher growth expectations for Amazing Athletics.

2. Spotting Potential Bargains or Overpriced Stocks

When a company’s P/E ratio is much lower than similar companies in the same industry, it might be:

• An undervalued bargain that other investors have overlooked
• A company with serious problems that’s rightfully being valued less

Similarly, a very high P/E ratio compared to similar companies might indicate:

• A stock that’s become too expensive and might be due for a price drop
• A truly innovative company that justifies the premium because of exceptional growth potential

3. Gauging Overall Market Sentiment

The P/E ratio can be calculated for entire stock indexes like the S&P 500, not just individual companies. This helps investors understand if the market as a whole might be overvalued or undervalued compared to historical averages.

Historical P/E Ratio Trends

Looking at P/E ratios throughout history gives us some interesting insights:

The Historical Average

For the S&P 500 (which represents 500 of America’s largest companies), the long-term average P/E ratio has been around 15-16. This means that, on average, investors have historically been willing to pay about $15-16 for every $1 of earnings across these major companies.

Notable Historical Periods

P/E ratios have varied widely throughout market history:

Low P/E Periods:

• During the early 1980s, the S&P 500’s P/E ratio fell to around 7-8
• After the 2008 financial crisis, many solid companies had P/E ratios below 10
• These periods often turned out to be excellent times to invest, though they didn’t feel that way at the time!

High P/E Periods:

• During the dot-com bubble of the late 1990s, the S&P 500’s P/E ratio soared above 30
• Some individual tech companies had P/E ratios over 100, or even had no earnings at all
• This extreme overvaluation eventually led to the dot-com crash

Recent Trends

In recent years, P/E ratios have generally been above their historical averages:

• Technology companies have led the way with higher multiples
• Low interest rates made stocks more attractive compared to bonds
• The S&P 500’s P/E ratio has frequently been in the 20-25 range during the 2020s

This has caused debate among investors about whether stocks are overvalued or if higher P/E ratios are justified by factors like low interest rates, technological innovation, and stronger company growth.

Different Types of P/E Ratios

Not all P/E ratios are calculated the same way. The two main types are:

Trailing P/E

This uses the company’s actual earnings from the past 12 months. It’s based on real results, not predictions.

Forward P/E

This uses predicted earnings for the next 12 months. It’s based on what analysts think will happen, which might be more relevant for the future but is less certain.

Let’s see how these might differ:

• If Super Sneakers earned $5 last year but is expected to earn $6.25 next year:
  • Trailing P/E: $50 ÷ $5 = 10
  • Forward P/E: $50 ÷ $6.25 = 8

The lower forward P/E suggests analysts expect earnings growth.

P/E Ratios for Index Funds vs. Individual Stocks

Now let’s talk about how P/E ratios relate to different investment approaches.

Index Funds and P/E Ratios

Index funds own hundreds or thousands of stocks that track a specific market index, like the S&P 500. When you invest in an index fund:

• You’re buying the average P/E ratio of all companies in that index
• Some companies in the index will have high P/E ratios, others will have low ones
• You don’t have to worry about picking the right P/E ratio for individual stocks

This simplifies your investment decisions. Instead of analyzing individual companies, you can look at the overall market P/E ratio to get a sense of whether stocks in general might be expensive or reasonably priced.

Individual Stocks and P/E Ratios

When picking individual stocks, P/E ratios become much more important:

• You’ll want to compare a company’s P/E ratio to its own historical average
• You should also compare it to other companies in the same industry
• Understanding why a P/E ratio is high or low becomes crucial

For example, a technology company might reasonably have a higher P/E ratio than a grocery store chain because it has more growth potential.

Does the P/E Ratio Matter for Long-Term Investors?

This is where things get interesting. How much should average investors care about P/E ratios?

For Index Fund Investors

If you’re investing in broad market index funds and have a very long time horizon (10+ years):

• The specific P/E ratio at which you buy matters less than consistently investing over time
• Market timing based on P/E ratios has proven difficult even for professional investors
• Dollar-cost averaging (investing regular amounts regardless of market conditions) helps reduce the impact of buying at high P/E moments

That said, being aware of extreme P/E situations can be helpful:

• If the market’s P/E ratio is extremely high (like during the dot-com bubble), you might consider investing a bit more cautiously
• If the market’s P/E ratio is unusually low (like during a major recession), it might be a good time to invest more aggressively if you have extra cash

For Individual Stock Investors

If you’re picking individual stocks, P/E ratios become much more important:

• A company with a P/E ratio of 100 needs tremendous growth to justify that valuation
• Companies with very low P/E ratios might be value traps with declining businesses
• Understanding the “why” behind a P/E ratio is critical to making good decisions

When P/E Ratios Can Be Misleading

P/E ratios have some limitations you should know about:

1. One-Time Events

A company might have unusually high or low earnings in a particular year due to special situations:

• A one-time tax benefit could artificially lower the P/E ratio
• A temporary expense like restructuring could make the P/E ratio look artificially high

2. Growth Stage Companies

Many fast-growing companies reinvest all their potential profits to fuel growth. This can result in:

• Low earnings despite strong business performance
• Very high P/E ratios that look expensive but might be justified
• Some high-growth companies may even have negative earnings (and thus no P/E ratio at all)

Amazon is a famous example of a company that had a sky-high P/E ratio for years because it reinvested heavily in growth rather than showing immediate profits.

3. Cyclical Industries

Some industries naturally go through boom and bust cycles:

• During good times, earnings are high and P/E ratios look low
• During industry downturns, earnings drop dramatically and P/E ratios spike
• This can trick investors into buying at the wrong time

For example, auto manufacturers and energy companies often show their lowest P/E ratios right before industry downturns.

How to Use P/E Ratios Wisely

Here’s how different types of investors might think about P/E ratios:

For Beginning Investors

• Focus on consistently investing in broad market index funds rather than worrying too much about P/E ratios
• Understand that the stock market has delivered good returns over very long periods despite fluctuations in P/E ratios
• If the overall market P/E ratio is extremely high by historical standards, consider saving a slightly higher percentage in other investments

For Intermediate Investors

• Use P/E ratios as one tool among many to evaluate potential investments
• Compare P/E ratios within industries rather than across different sectors
• Look at both trailing and forward P/E ratios to get a more complete picture
• Consider other valuation metrics alongside P/E ratios

For Advanced Investors

• Analyze why a company’s P/E ratio differs from its peers
• Consider how current interest rates affect appropriate P/E ratios
• Look at P/E ratios in relation to expected growth rates (the PEG ratio)
• Understand industry-specific factors that influence appropriate P/E levels

The Bottom Line: Should You Care About P/E Ratios?

So, after all this discussion, how much should the average investor worry about P/E ratios?

For long-term index fund investors: P/E ratios are worth understanding but probably shouldn’t drive your main investment strategy. Consistent investing over time tends to work well regardless of entry point P/E ratios, though extreme valuations might warrant some caution.

For individual stock pickers: P/E ratios are essential to understand and analyze, but should never be used in isolation. They’re one important piece of a larger analytical puzzle.

Remember these key points:

• A low P/E ratio doesn’t automatically mean a stock is a good deal
• A high P/E ratio doesn’t automatically mean a stock is overpriced
• Understanding why a P/E ratio is what it is matters more than the number itself
• For most people, focusing on regular investing in diversified funds matters more than finding the perfect P/E ratio

The most successful investors typically use P/E ratios as one tool in their toolbox, not as the only measure of investment value. By understanding what this number means and its limitations, you’ll be better equipped to make informed investment decisions—whether you choose to focus on this metric or not.