What is the P/E Ratio? The Most Common Valuation Multiple

The Price-to-Earnings (P/E) ratio relates a company's share price to its earnings per share. It indicates what the market is willing to pay for $1 of profit.

The Price-to-Earnings (P/E) Ratio is the most widely used metric for determining if a stock is over- or undervalued. It is calculated by dividing the current share price by the Earnings Per Share (EPS). A P/E of 20 means an investor is willing to pay $20 for every $1 of annual earnings. It essentially represents the 'payback period' in years, assuming earnings remain constant.

There are two main types: Trailing P/E, which uses the earnings from the past 12 months, and Forward P/E, which uses analyst projections for the next year. In 2024, the S&P 500 had an average trailing P/E of approximately 25x, which was historically high compared to the 100-year average of roughly 16x. High P/E ratios typically indicate that the market expects high growth in the future.

P/E ratios can be misleading if a company has a significant amount of debt. Since the 'Price' only accounts for equity value and 'Earnings' are calculated after interest payments, the P/E does not reflect the total capital structure. For this reason, quants often prefer Enterprise Value to EBITDA (EV/EBITDA) for cross-industry comparisons. Additionally, P/E ratios are useless for companies with negative earnings, which is common for early-stage biotech and software firms.