P/E Ratio: How to Use It When Picking Stocks
P/E is the best-known valuation ratio — every broker app shows it. But on its own it tells you almost nothing. We look at how to compare P/E properly, work through an example and see where it misleads.
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The formula in one minute
P/E = share price / earnings per share (EPS). Or, which is the same thing, market cap / net profit. It answers the question: how many years would it take the company, at its current earnings, to "earn back" its price. Definitions are in our glossary: P/E and EPS. Here we look at how to use it.
| Type of P/E | Based on which earnings | Pro | Con |
|---|---|---|---|
| Trailing (TTM) | Actual results for the last 12 months | Real numbers | Looks backwards |
| Forward | Analysts' forecast for the year ahead | Takes growth into account | The forecast may not come true |
| Adjusted | Earnings excluding one-off items | Shows the core business | The company decides itself what counts as "one-off" |
Example: two companies
The numbers are made up. Both companies are in the same industry.
| Company A | Company B | |
|---|---|---|
| Share price | $120 | $30 |
| Earnings per share (EPS) | $6 | $3 |
| P/E | 20 | 10 |
| Expected annual earnings growth | 20% | 3% |
| PEG = P/E / growth | 1.0 | 3.3 |
| Industry average P/E | 16 | 16 |
At first glance B is twice as "cheap". But its earnings are barely growing, and once you factor in growth (PEG), B turns out to be the more expensive one. Company A trades above the industry P/E, and the market pays that premium for growth. If growth slows, the premium can disappear and the price can fall even if earnings don't drop.
The takeaway: P/E is where the question starts, not the answer. Next you need to understand why it is what it is: look at the financial statements (how to read a company's financial statements) and other ratios.
How to use it, step by step
- Compare within the industry. Comparing the P/E of a bank and a tech company makes no sense — they grow at different speeds and carry different risks.
- Compare with the company's own history. If P/E has usually been 15–18 and is now 30, the market expects a lot.
- Check the quality of earnings. A one-off asset sale can inflate earnings and push P/E down for a year.
- Add growth — PEG. That's P/E divided by earnings growth in percent. Around 1 means growth is priced moderately.
- Add other ratios: P/S for loss-making companies, EV/EBITDA for companies with lots of debt.
Where P/E misleads
| Situation | What P/E shows | What is really going on |
|---|---|---|
| Cyclical company at the peak | Low — "cheap" | Earnings are at a high and may fall next |
| One-off profit | Dropped sharply | The core business hasn't changed |
| Loss | Negative or not calculated | You need other metrics |
| Heavy debt | Not visible | Shareholders carry more risk |
| Share buyback | EPS rises, P/E falls | The business's profit may not have grown |
The first case is especially tricky. For commodity and cyclical companies, P/E is usually lowest right at the top of the cycle, when earnings are at their peak.
How much to put into one idea
Even if P/E and the financials look good, you can still be wrong. Example: a $5,000 portfolio. The limit per stock is 5%, i.e. $250. Write down your review trigger in advance: earnings fall two quarters in a row, or P/E climbs far above the industry without growth to justify it. If the stock falls 40%, you lose $100, or 2% of the portfolio. Unpleasant, but not critical. How to build a set of 15–20 such positions is covered in how to build a stock portfolio as a beginner.
Common mistakes
- Buying everything with a low P/E. Often the market is right, and the low valuation reflects falling earnings.
- Avoiding everything with a high P/E. That way you can miss companies that keep growing for years.
- Comparing different industries and different reporting currencies without adjusting.
- Looking at a single number and never opening the report.
What you are risking
Valuation ratios don't predict the price. A stock with the "right" P/E can fall for months if the business gets worse, interest rates rise or the market as a whole heads down. A mistake on one company without a position limit can cost a large part of your portfolio. Valuation ratios and stock screeners are covered in detail in the Aspiro Academy (in Russian) lesson "Valuation ratios and the stock screener".
Aspiro Invest — a medium-term portfolio: what to hold, when to review it and where the protective levels are.
- P/E = price / earnings per share. Compare it with the industry and the company's own history.
- Account for growth with PEG and check the quality of earnings.
- A low P/E at a cyclical company often signals peak earnings, not a bargain.
- No more than 5% of the portfolio in one idea, with a review trigger set in advance.
FAQ
What is a normal P/E ratio?
There is no single norm. P/E is compared with competitors in the same industry and with the company's own history. Fast-growing companies usually have a higher P/E, banks and utilities a lower one. A low P/E on its own doesn't mean "cheap".
What does a negative P/E mean?
The company made a loss, so the ratio loses its meaning. For loss-making companies, look at other ratios such as P/S — price to sales — and at when the business might become profitable.
What is the difference between trailing and forward P/E?
Trailing P/E (TTM) is based on actual earnings over the last 12 months. Forward P/E is based on analysts' forecast for the next year. Forecasts may not come true, so it's useful to look at both.
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