P/E vs. Earnings yield

The inverse of the P/E ratio is the earnings yield (which can be thought of like the E/P ratio). The earnings yield is thus defined as EPS divided by the stock price, expressed as a percentage.

If Stock A is trading at $10, and its EPS for the past year was 50 cents (TTM), it has a P/E of 20 (i.e., $10 / 50 cents) and an earnings yield of 5% (50 cents / $10). If Stock B is trading at $20 and its EPS (TTM) was $2, it has a P/E of 10 (i.e., $20 / $2) and an earnings yield of 10% ($2 / $20).

The earnings yield as an investment valuation metric is not as widely used as its P/E ratio reciprocal in stock valuation. Earnings yields can be useful when concerned about the rate of return on investment. For equity investors, however, earning periodic investment income may be secondary to growing their investments' values over time. This is why investors may refer to value-based investment metrics such as P/E ratio more often than earnings yield when making stock investments.

The earnings yield is also useful in producing a metric when a company has zero or negative earnings. Since such a case is common among high-tech, high growth, or start-up companies, EPS will be negative producing an undefined P/E ratio (sometimes denoted as N/A). If a company has negative earnings, however, it will produce a negative earnings yield, which can be interpreted and used for comparison.

P/E vs. PEG Ratio

A P/E ratio, even one calculated using a forward earnings estimate, don't always tell you whether or not the P/E is appropriate for the company's forecasted growth rate. So, to address this limitation, investors turn to another ratio called the PEG ratio.

A variation on the forward P/E ratio is the price-to-earnings-to-growth ratio, or PEG. The PEG ratio measures the relationship between the price/earnings ratio and earnings growth to provide investors with a more complete story than the P/E on its own. In other words, the PEG ratio allows investors to calculate whether a stock's price is overvalued or undervalued by analyzing both today's earnings and the expected growth rate for the company in the future. The PEG ratio is calculated as a company’s trailing price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. The PEG ratio is used to determine a stock's value based on trailing earnings while also taking the company's future earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. For example, a low P/E ratio may suggest that a stock is undervalued and therefore should be bought – but factoring in the company's growth rate to get its PEG ratio can tell a different story. PEG ratios can be termed “trailing” if using historic growth rates or “forward” if using projected growth rates.

Although earnings growth rates can vary among different sectors, a stock with a PEG of less than 1 is typically considered undervalued since its price is considered to be low compared to the company's expected earnings growth. A PEG greater than 1 might be considered overvalued since it might indicate the stock price is too high as compared to the company's expected earnings growth.

Absolute vs. Relative P/E

Analysts may also make a distinction between absolute P/E and relative P/E ratios in their analysis.

Absolute P/E

The numerator of this ratio is usually the current stock price, and the denominator may be the trailing EPS (TTM), the estimated EPS for the next 12 months (forward P/E) or a mix of the trailing EPS of the last two quarters and the forward P/E for the next two quarters. When distinguishing absolute P/E from relative P/E, it is important to remember that absolute P/E represents the P/E of the current time period. For example, if the price of the stock today is $100, and the TTM earnings are $2 per share, the P/E is 50 ($100/$2).

Relative P/E

The relative P/E compares the current absolute P/E to a benchmark or a range of past P/Es over a relevant time period, such as the past 10 years. The relative P/E shows what portion or percentage of the past P/Es the current P/E has reached. The relative P/E usually compares the current P/E value to the highest value of the range, but investors might also compare the current P/E to the bottom side of the range, measuring how close the current P/E is to the historic low.

The relative P/E will have a value below 100% if the current P/E is lower than the past value (whether the past high or low). If the relative P/E measure is 100% or more, this tells investors that the current P/E has reached or surpassed the past value.

Limitations of Using the P/E Ratio

Like any other fundamental designed to inform investors on whether or not a stock is worth buying, the price-to-earnings ratio comes with a few important limitations that are important to take into account, as investors may often be led to believe that there is one single metric that will provide complete insight into an investment decision, which is virtually never the case. Companies that aren't profitable, and consequently have no earnings – or negative earnings per share, pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E, others assign a P/E of 0, while most just say the P/E doesn't exist (not available - N/A) or is not interpretable until a company becomes profitable for purposes of comparison.

One primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due both to the differing ways companies earn money and to the differing timelines during which companies earn that money.

As such, one should only use P/E as a comparative tool when considering companies in the same sector, as this kind of comparison is the only kind that will yield productive insight. Comparing the P/E ratios of a telecommunications company and an energy company, for example, may lead one to believe that one is clearly the superior investment, but this is not a reliable assumption.

Other P/E Considerations

An individual company’s P/E ratio is much more meaningful when taken alongside P/E ratios of other companies within the same sector. For example, an energy company may have a high P/E ratio, but this may reflect a trend within the sector rather than one merely within the individual company. An individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.

Moreover, because a company’s debt can affect both the prices of shares and the company’s earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they take on. The one with more debt will likely have a lower P/E value than the one with less debt. However, if business is good, the one with more debt stands to see higher earnings because of the risks it has taken.

Another important limitation of price-to-earnings ratios is one that lies within the formula for calculating P/E itself. Accurate and unbiased presentations of P/E ratios rely on accurate inputs of the market value of shares and of accurate earnings per share estimates. While the market determines the value of shares and, as such, that information is available from a wide variety of reliable sources, this is less so for earnings, which are often reported by companies themselves and thus are more easily manipulated. Since earnings are an important input in calculating P/E, adjusting them can affect P/E as well.