Analysts have many ways to determine if a stock’s price is cheap or expensive, relative to its performance. One way to measure this is the price-to-earnings ratio, or P/E ratio.
Put simply, the P/E ratio is the stock’s price divided by the earnings per share that the stock delivered over the last 12 months (also referred to as TTM, or “trailing twelve months”). The price-to-earnings ratio should, in theory, represent the return of a business against how much it costs to buy a share of that company.
For example, Amazon currently has a P/E ratio of about $83 (given where the stock was trading on Jan. 16, 2020). This means that for every $1 invested in Amazon, you would be investing in about $83 of earnings. That’s why P/E ratios are often called multiples; it represents the multiples of earnings purchased when investing in a stock.
Based on data from macrotrends.net, the S&P 500 index is currently trading at a P/E of around 21. Companies trading above that, like Amazon, may be considered more expensive than the market. Stocks that are trading under 21 may be considered cheaper than the market.
But is 21 itself expensive by the S&P 500’s historical standards? The S&P 500 P/E ratio jumped during the dot-com bubble. During the financial crisis the S&P 500 P/E ratio rose to as high as 122, in early 2009.
During downturns, P/E ratios in the market tend to rise because compression on earnings causes the denominator of the P/E ratio to fall sharply. When this happens, it raises the P/E ratios on S&P 500 companies.
But of course, analysts are usually interested in future performance of a stock. Forward P/E ratio offers a way to measure future valuations of a company, by measuring earnings over the next 12 months (as opposed to TTM).
According to Goldman Sachs, forward P/E ratios as of Dec. 31, 2019 were around 18.8x, which implies earnings will grow if current prices hold steady.
Comparing forward P/E ratios to backwards-looking P/E ratios could show relative valuations. But when looking at forward P/E ratios, analysts should note the uncertainty baked into the figure. For example, earnings forecasts might not be correct. And the price itself might move over time, especially if it’s a high volatility stock.
And P/E ratios are impossible to calculate for companies that don’t currently produce earnings, such as Uber.
But overall, P/E ratios are a commonly used way for analysts to at least baseline a stock’s value.
Brian Cheung is a reporter at Yahoo Finance. Valentina Caval is a producer for On the Move.