Fundamental Analysis· Lesson 4 of 8· 6 min

The P/E Ratio: Expensive or Cheap?

Share price ÷ earnings per share = P/E ratio: how much you're willing to pay for each $1 of annual profit. A high P/E is buying expectations of growth.

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Text version · Fundamental Analysis, lesson 4: “The P/E Ratio: Expensive or Cheap?”

Share price ÷ earnings per share = P/E ratio: how much you're willing to pay for each $1 of annual profit. A high P/E is buying expectations of growth.

How much you pay for $1 of profit

P/E ratio = share price ÷ EPS. A P/E of 20 means that, if profits stayed flat, it would take about 20 years to “earn back” the price. A high P/E is a bet on future growth.

Two sources of return

Stock return ≈ earnings growth + change in P/E. PEG factors growth into how cheap or expensive a stock is: a company growing 30% at a P/E of 40 may be cheaper than one growing 5% at a P/E of 20.

P/E can be misleading too

When profit is near 0 the P/E becomes huge, and when there's a loss it's meaningless. Cyclical stocks have their lowest P/E at peak profits: when they look cheapest is often when they're most expensive.

Key takeaways

P/E ratio = share price ÷ EPS, roughly "how many years to earn back your money if profit stays flat".
Stock returns come from two things: earnings growth and changes in the P/E ratio. Buy a great company too expensively and you may make nothing for years.
PEG = P/E ratio ÷ earnings growth rate (as a percentage), which factors in growth before comparing expensiveness.
When profit is close to 0 or at a cyclical peak, the P/E ratio is misleading: cyclical stocks are often most expensive when their P/E is lowest.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

Keep the defaults (buy at 30×, earnings grow 12% a year, 20× in 5 years): roughly what's the 5-year total return? And per year?
Set the P/E in 5 years back to 30: what's the annualized return now? Is it the same as the earnings growth rate?
Buy at a P/E of 60, earnings grow 10% a year, ending P/E 20: how many years do you need to hold before the stock stops losing money?
Earnings grow 10% a year, hold for 5 years, buy at a P/E of 30: how low does the ending P/E have to fall for the total return to be about 0?

Quiz and explanations

1. The share price is $60 and EPS is $3. What's the P/E ratio?: Answer: 20.$60 ÷ $3 = 20.
2. Earnings grow 10% a year, but the P/E ratio falls from 40 to 20. Roughly where's the share price after five years?: Answer: Down about 20%.1.1⁵ ≈ 1.61, times 20/40 = 0.81, down about 19%.
3. The share price is $50, EPS is $2.5, and earnings are expected to grow 25% a year. What's the PEG?: Answer: 0.8.P/E = 50 ÷ 2.5 = 20; PEG = 20 ÷ 25 = 0.8.

Terms in this lesson

EPS: Net income ÷ total shares: how much profit each share earns.
P/E ratio (P/E Ratio): Share price ÷ earnings per share: what you pay for each $1 of annual profit; a high P/E means the market expects faster growth.
PEG: P/E ÷ earnings growth rate (in percent), which factors growth into valuation; around 1 is often seen as fair.