What is a P/E ratio?
The price-to-earnings (P/E) ratio compares a company's share price to how much
profit it generates per share, giving you a rough sense of how expensive a stock is relative to
its earnings. The formula: P/E = Share Price / Earnings Per Share (EPS).
If a company trades at $60 per share and earned $3 per share over the last year, its P/E ratio is 60 / 3 = 20. In plain terms: investors are currently paying $20 for every $1 of the company's annual earnings.
Trailing P/E vs. forward P/E
When you see a P/E ratio quoted, it's calculated one of two ways. Trailing P/E uses the actual earnings per share reported over the past 12 months — a look backward at real results. Forward P/E instead uses analysts' estimated EPS for the next 12 months — a forecast, which can turn out to be wrong. A stock can look expensive on a trailing basis but reasonable on a forward basis if earnings are expected to grow quickly, or vice versa if a slowdown is expected.
What counts as a "good" P/E?
There's no universal cutoff for "cheap" or "expensive." The S&P 500 has historically averaged somewhere around the mid-to-high teens over long stretches, but that average blends together very different kinds of businesses. Slow-growing, capital-intensive sectors like utilities or banks often trade at single digits to mid-teens as a matter of course. Fast-growing technology or healthcare companies can justifiably command multiples of 30, 40, or higher if the market expects earnings to grow rapidly enough to catch up to the price.
Two companies both trading at a P/E of 25 aren't necessarily equally "expensive." If Company A's earnings are expected to grow 5% a year and Company B's are expected to grow 25% a year, the same P/E represents a much more demanding valuation for Company A than for Company B — the growth rate the market is implicitly paying for is very different.
P/E's biggest limitation: it says nothing about growth on its own
Because P/E alone doesn't account for how fast earnings are growing, investors often pair it with a PEG ratio (P/E divided by expected earnings growth rate) to sanity-check whether a high multiple is justified. A PEG near or below 1.0 is often read as reasonably priced relative to growth expectations — though the result is only as reliable as the growth estimate that goes into it.
Common mistakes when using P/E ratio
1. Comparing P/E across different industries
A bank trading at a P/E of 10 and a software company trading at a P/E of 35 aren't necessarily mispriced relative to each other — different industries carry structurally different typical multiples based on growth rates, capital needs, and earnings predictability. Compare P/E within the same sector, or against a company's own historical average, rather than across unrelated industries.
2. Ignoring negative or near-zero earnings
P/E breaks down for companies with negative or negligible earnings, since dividing by a tiny or negative number produces a meaningless or undefined result. Early-stage or turnaround companies are usually better evaluated with other metrics, like price-to-sales, until earnings normalize.
3. Treating a low P/E as automatically "cheap"
A stock can carry a low P/E because the market has correctly priced in declining future earnings — a struggling retailer or a company losing market share can look statistically "cheap" right before its earnings fall further, making the P/E rise again even as the price stays flat or drops. Low P/E is a prompt to dig into why, not a standalone signal to buy.