What Is a P/E Ratio? In Plain Words

The formula

Investor.gov, the U.S. Securities and Exchange Commission’s investor site, states the formula in words:

P/E ratio = current stock price ÷ current earnings per share

FINRA states the same formula. FINRA says a P/E ratio is calculated by dividing the stock price by its EPS. EPS is short for earnings per share. FINRA’s “Evaluating Stocks” page says the same thing in slightly different words: the P/E ratio is calculated by dividing the current price of a stock by its EPS.

A ratio is a comparison of two numbers, worked out by dividing one by the other. Here, the two numbers are the price of one share and the earnings for one share.

What earnings per share means

Earnings are a company’s profit. Earnings per share is that profit split across the company’s shares, so it shows the profit for one share.

Investor.gov’s P/E entry explains how earnings per share are calculated in that entry: earnings per share are calculated by dividing the earnings for the past 12 months by the number of common shares outstanding.

Investor.gov’s separate glossary entry for the term itself is shorter. It defines earnings per share as: “A public company’s net profit divided by the number of its common shares.” Net profit is the profit left after costs are taken away.

FINRA gives the same idea. FINRA says EPS is the measure of a company’s profitability per outstanding share of common stock. FINRA says common stock shares represent equity ownership in a company. Equity ownership means owning a share of the company.

FINRA also says you will often see two EPS measures at the bottom of an income statement — basic and diluted. An income statement is a company report that shows its sales, costs, and profit. FINRA says basic EPS is computed by dividing a company’s net income by the number of outstanding common shares. If the company issued new shares or bought back any shares during the quarter, it would use the weighted-average number of common shares.

FINRA’s “Evaluating Stocks” page adds what EPS is used for. It says that, calculated by dividing a company’s total earnings by the number of shares, a company’s earnings per share allows you to compare the financial results of companies of different sizes. It also says EPS is one indication of a company’s current financial strength.

Worked examples, from FINRA

Investor.gov’s P/E entry gives no worked number example. FINRA does. Both examples below are FINRA’s own, from its page “Financial Performance Metrics Every Investor Should Know.”

Put in plain steps, using FINRA’s numbers only: $100 divided by $5 equals 20. So the P/E ratio in FINRA’s example is 20.

What the number is used to compare

Investor.gov says a company’s P/E ratio is a way of gauging whether the stock price is high or low compared to the past or to other companies.

FINRA says a P/E ratio can help you compare the valuation of different stocks. Valuation means how the market prices a company. FINRA says P/E is generally used to compare companies in the same industry. An industry is a group of companies that do similar business.

FINRA’s “Evaluating Stocks” page calls the P/E ratio a commonly quoted measure of stock value. It puts the meaning in one sentence: “In a nutshell, P/E tells you how much investors are paying for a dollar of a company’s earnings.”

FINRA’s “Evaluating Stocks” page also says to understand how these ratios compare to the market as a whole and to a company’s particular industry, since there can be significant variation in the average ratio across industries.

Higher and lower P/E, in the sources’ own words

This page does not call a high P/E good or bad, and it does not call a low P/E good or bad. It reports only what FINRA states.

FINRA says: “A stock with a comparatively high P/E ratio trades at a higher price relative to its EPS than a stock with a lower P/E—in other words, it might be relatively expensive with respect to its earnings.” Note FINRA’s word “might.” FINRA does not state it as a rule.

FINRA also states a general tendency, not a rule for any one stock: “Fast-growing companies tend to have higher P/E ratios, while firms in more mature, slow-growth industries tend to have lower P/Es.”

FINRA’s “Defining the Value of an Investment” page makes the same kind of point about industries. It says different industries have different “normal” values, and gives this example: “Tech companies usually have higher valuation metrics than utilities, for example.”

Cautions the sources state

FINRA’s value investing page also notes that which precise metrics qualify a stock as value is subjective. Subjective means it depends on judgment, not on one fixed rule. That page says value investors consider various financial performance metrics, including the price-to-earnings (P/E) ratio and the price-to-book (P/B) ratio, and many others.

FINRA’s “Defining the Value of an Investment” page says looking at multiple measures can provide a fuller picture of investment value than a single valuation method or metric. It also says that, rather than looking at a company’s metrics in isolation, you should compare the current metrics to the company’s historical values and industry averages.

What this page does not cover

The official pages read in full for this page do not name or explain two separate types called “trailing P/E” and “forward P/E,” so this page does not explain them. Investor.gov’s P/E entry uses earnings for the past 12 months in its earnings per share calculation. That is all that entry states about the time period.

No source read for this page states a number that counts as a “good” P/E, and no source states a cut-off number above or below which a stock is a buy or a sell. This page states no such rule, because the sources do not.

This page does not pick stocks, does not name any real company as an example, and does not say what any stock price will do next.

Words to know

P/E ratio: Short for price-earnings ratio. Calculated by dividing the current stock price by the current earnings per share.

Earnings per share (EPS): A public company’s net profit divided by the number of its common shares. In Investor.gov’s P/E entry, the earnings used are the earnings for the past 12 months, divided by the number of common shares outstanding.

Common shares outstanding: The common shares counted in the calculation. FINRA describes EPS as a company’s profitability per outstanding share of common stock, and says common stock shares represent equity ownership in a company.

Net income / net profit: The profit a company has left. FINRA describes net income as what remains when total expenses are subtracted from total sales, or revenue.

Valuation: How the market prices a company. FINRA says a P/E ratio can help you compare the valuation of different stocks.

This page is general information only. It is not financial advice.