The P/E ratio (price-to-earnings) is the most-used ratio to judge whether a stock is cheap or expensive. It answers a very concrete question: how many years of current profit are you paying for when you buy the share?
How it's calculated
The P/E is obtained by dividing the share price by earnings per share (EPS, i.e. total profit divided by the number of shares):
- P/E = Price ÷ Earnings per share
If a share costs $100 and the company earns $5 per share a year, its P/E is 20. The intuitive reading: at this rate of profits, it would take you 20 years to recoup what you invested. That's why a high P/E means "expensive" and a low one "cheap"… though, as you'll see, with caveats.
Why a high P/E isn't always expensive
The market doesn't pay for today's profit, but for tomorrow's. A company growing 25% a year deserves a higher P/E than a stagnant one, because its future profits will be far larger. So comparing the P/E of a fast-growing tech company with that of a mature utility makes no sense: they are different businesses with different expectations.
The same in reverse: a very low P/E can be a value trap. Sometimes the market pays little because it anticipates that profits will fall. Cheap isn't the same as a good opportunity.
The key: compare it with its sector
That's why at StockSemáforo we don't judge the P/E with a fixed threshold, but by comparing it with the normal P/E of its sector. A P/E of 30 scores well in software (where it's common) and badly in banking (where it's expensive). That sector comparison is the honest way to use the ratio. You can read how we apply it in how the traffic light works.
Trailing and forward P/E
There are two variants. The trailing P/E uses the profit already reported over the last twelve months: it's a fact, not an opinion. The forward P/E uses the profit the company estimates for next year. We work with published, real data, not forecasts, so we use the trailing P/E.
How to use it well
The P/E is a thermometer, not a full diagnosis. Always pair it with growth (a high P/E is justified if the company grows) and with the quality of the business (ROE, margins, debt). If you want to see any stock's P/E compared with its sector instantly, type its ticker into the analyzer. And for the underlying question, read how to tell if a stock is cheap or expensive.