P/E Ratio
The price-to-earnings ratio (P/E) is a stock’s price divided by its earnings per share. It tells you how many dollars the market charges for one dollar of the company’s annual profit, which makes it the most widely used shorthand for how expensive a stock is.
The math
A stock at 50 dollars with earnings of 2.50 dollars per share trades at a P/E of 20. Now take two companies at that same P/E of 20.
One grows earnings 25 percent a year, the other shrinks 10 percent a year. Three years later, the same 50 dollar price tells two opposite stories.
| Grower (+25%/yr) | Shrinker (-10%/yr) | |
|---|---|---|
| EPS today | $2.50 | $2.50 |
| EPS in 3 years | $4.88 | $1.82 |
| P/E on those earnings | 10x | 27x |
Identical P/E today, opposite outcomes. The multiple without the trajectory is half a number.
The trap
Cyclical companies show their lowest P/E at the top of the cycle, when earnings are at a peak that will not last. A steelmaker at 6 times record earnings is often more expensive than it looks, and the “cheap” label is what pulls investors in right before earnings normalize and the multiple doubles on its own.
The move
Never use a P/E in isolation. Compare it to the company’s own 5 and 10 year range and to direct competitors, not to the whole market.
Ask what the E is made of: one-off gains, peak margins, or repeatable profits. And cross-check with free cash flow yield, because earnings are an opinion while cash is a fact.