The price-to-earnings (P/E) ratio is calculated by dividing a company’s stock price per sha💛re by its earnings per share (EPS). In theory, the P/E ratio can indicate whether a stock is overvalued or undervalued. An undervalued stock is likely a good investment, while an overvalued stock is not.

While the P/E ratio is a useful stock valuation measure, it can be misleading to investors due to different methods of accounting.

How the Price-to-Earnings (P/E) Ratio Works

The price-to-earnings (P/E) ratio measures the share price of a company's stock relative to the earnings per share (EPS). It indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings.

To calculate the P/E ratio, divide the price of a company's stock by its earnings per share:

P/E Ratio = (market value per share) ÷ (earnings per share)

The P/E ratio is helpful for evaluating the relative value of a company's stock, which can indicate whether it is currently over- or undervalued. A high 澳洲幸运5官方开奖结果体彩网:P/E ratio may sugges🔴t that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.

Limitations of the Price-to-Earnings Ratio

The P/E ratio is used by investors and analysts to assess the value of a company's stock, but, like any other calculation used to evaluate a stock, it has limitations.

A primary limitation of using P/E ratios becomes evident when investors compare the P/E ratios of different companies. Valuations and business models may vary wildly across sectors, and it is best to use P/E as a tool to compare stocks in the same s༺ector rather than multiple sectors.

However, there are other limitat🐬ions to the P/E ratio that can be misleading, making it difficult for investors to accurately value a single company or compare the values of multiple companies in the same industry.

Earnings Per Share Can Be Misleading

In the P/E ratio calculation, the stock price per share is set by the market. The EPS value, however, varies depending on the earnings data used. Companies can use different accounting methods to calculate 澳洲幸运5官方开奖结果体彩网:earnings per share, which can impact the final number given for earningsܫ per share.

Earnings per share can be calculatedඣ using one of two types of data: past data or projected future data. In either case, the data used to calculate the P/E ratio can not be taken as an absolute indicator of either the current or future value of a company.

The trailing P/E ratio is calculated using past data. However, past rℱeturns do not guarantee future returns, and there is no way to know whether earnings will remain the same.

The forward P/E is based on projections of future✃ earnings. However, these projections may not be accurate; depending on who is calculating these projections, they may be inherently faulty or mis🍨leading.

Companies can cherry-pick the accounting method that makes them look best. This makes it difficult for investors to accurately value a single company or compare various companies since it is impossible to know if they are comparing similar figures. Comparing one company’s P/E ratio based on trailing earnings to another’s forward earnings creates an apples-to-oranges comparison that can be misleading to investors.

Example of a P/E Ratio🎃 Comparison Between Stocks

A quick look at P/E ratios for Apple (AAPL) and Amazon (AMZN) illustrates the 澳洲幸运5൲官方开奖结果体彩网:dangers of using only the P/E ratio to evaluate a company.

In mid-December, 2018, Apple traded at $165.48 with a P/E ratio (TTM) of 13.89. On the same day, Amazon’s stock price was $1,591.91 with a P/E ratio of 89.19.

However, one of the reasons Amazon’s P/E was so much higher than Apple's at the time was that its efforts to expand aggressively on a wide scale had kept earnings somewhat suppressed and the P/E ratio high. If these two stocks were compared based on P/E alone, it would be impossible to make a reasonable evaluation. A 澳洲幸运5官方开奖结果体彩网:low P/E ratio does not ⛦automatically mean a stock is undervalued. Similarly, a high P/E ratio does not necessarily mean a company is overvalued.

Or, in another example, on Oct. 18, 2024, Apple traded at $235 per share with a P/E ratio of 30.96. On the same day, Amazon’s stock price was $188.99 with a P/E ratio of 45.11. While not as great a difference as in 2018, there is still a significant gap between the two P/E ratios. However, in this instance, the P/E ratio for Amazon is its trailing P/E (based on past data), while the P/E for Apple is its forward P/E (based on future projections). Amazon's forward P/E ratio on that same date was 31.95—much more similar to Apple's. In this case, c🐷herry-picking the type of P/E ratio used created a misleading comparison between the two companies.

The Bottom Line

The P/E ratio compares the market price of a company's stock to its earnings-per-share. It is used by investors and analysts to determine whether a company's stock is realistically valued. A low P/E ratio can indicate that a stock is undervalued.

However, the P/E ratio can be misleading. Earnings-per-share is calculated based on either past data or projected future data, neither of which give a completely accurate picture of a company's earnings. Companies also can select which method of accounting they use to calculate their P/E ratio, which can make comparing P/E ratios between companies misleading.

Investors should use more than just the P/E ratio when evaluating a company or comparing multiple companies in order to get a more complete🐬 picture of their overall values.