If you’ve ever turned on CNBC or Bloomberg TV, you’ve heard the talking heads say something along the lines of “This stock has a P/E of 15, while the S&P 500 Index has an average P/E of 20.” The price-to-earnings ratio (P/E for short) is a key fundamental indicator of whether a stock is undervalued or overvalued in relation to the overall market or its industry.
Price/earnings ratio explained
The price-to-earnings ratio is easy to calculate; it is the current closing price of the stock divided by its trailing 12-month earnings per share (EPS). Forward P/E is calculated by dividing the current closing stock price by the projected EPS for the next fiscal year; it typically uses analyst estimates or the company’s own guidance for earnings.
When a stock has P/E lower than its industry, it may be undervalued; price-earnings above the industry or index level can mean a stock is pricey.
P/E isn’t the be-all, end-all of fundamental analysis; it’s just one widely used and quoted indicator. When doing your due diligence, consider other factors, including fundamental ratios (price-to-book value, price-to-sales and more), industry growth, macroeconomic trends and more.
Of course, not every company can calculate a P/E ratio, for obvious reasons. Consider the case of Advanced Micro Devices (AMD), which recently had a trailing 12-month diluted EPS of -$0.54. Because AMD did not generate any earnings, its P/E is null. When a stock has a net loss — or simply breaks even for a period — there is no P/E to speak of. On the other hand, the semiconductors industry — which includes AMD — had an industry average of 23.9 over the same period; thus, it is fair to say that AMD could be overvalued compared to its industry.
The price-to-earnings ratio is widely used by fundamental investors and traders to indicate if a stock is overvalued or undervalued. Comparing company P/E to industry averages — in conjunction with technical and other fundamental analysis — can give an idea of how a stock might move next.
Jeff Bishop is lead trader at TopStockPicks.com. He runs short-term trading strategies, using stocks, options and leveraged ETFs.