How to Read P/E Ratios: A Beginner’s Guide

The Price-to-Earnings (P/E) ratio is one of the most widely used metrics in stock analysis. Understanding how to read and interpret P/E ratios is essential for evaluating stock valuations and making informed investment decisions.

What is the P/E Ratio?

The P/E ratio measures how much investors are willing to pay for each dollar of a company’s earnings.

Formula: P/E Ratio = Stock Price / Earnings Per Share (EPS)

Example Calculation

If a stock trades at $100 and has earnings of $5 per share:

P/E Ratio = $100 / $5 = 20

This means investors are paying $20 for every $1 of annual earnings.

Types of P/E Ratios

1. Trailing P/E (TTM - Trailing Twelve Months)

What it is: Uses earnings from the past 12 months

Pros:

Based on actual, reported earnings
No estimation or guesswork
Easy to verify from financial statements

Cons:

Backward-looking (doesn’t reflect future growth)
Can be distorted by one-time events
Less useful for rapidly changing businesses

2. Forward P/E

What it is: Uses projected earnings for the next 12 months

Pros:

Forward-looking, incorporates growth expectations
More relevant for investment decisions
Smooths out temporary earnings fluctuations

Cons:

Based on estimates that may be wrong
Analysts’ projections can be overly optimistic
Subject to revision as conditions change

3. Shiller P/E (CAPE - Cyclically Adjusted P/E)

What it is: Uses average earnings over the past 10 years, adjusted for inflation

Use case: Primarily used for market-level valuation (S&P 500), not individual stocks

Benefit: Smooths out economic cycles for long-term perspective

What is a “Good” P/E Ratio?

There’s no universal answer—context matters enormously.

General Guidelines

Low P/E (5-15): Potentially undervalued, but may indicate concerns about future growth
Medium P/E (15-25): Fair valuation for many established companies
High P/E (25+): High growth expectations, but potentially overvalued

Industry Context is Critical

Different industries have different “normal” P/E ranges:

Low P/E Industries (typically 5-15):

Banks and financial services
Energy companies
Mature industrials
Utilities

Medium P/E Industries (typically 15-25):

Consumer goods
Retail
Healthcare
Telecommunications

High P/E Industries (typically 25-50+):

Technology
Biotech
High-growth software
E-commerce

Why the difference?

Growth expectations vary by industry
Risk profiles differ
Capital intensity and returns vary
Market maturity affects valuations

Interpreting P/E Ratios

Low P/E Ratio: Opportunity or Warning?

Potential Positives:

Undervalued relative to earnings
Value investment opportunity
Margin of safety built in

Potential Negatives:

Declining business or industry
Earnings quality concerns
High debt or financial risk
Market expects earnings to decline

What to check:

Is the business model under threat?
Are earnings sustainable?
How does it compare to historical P/E?
What are peers’ P/E ratios?

High P/E Ratio: Growth Story or Bubble?

Potential Positives:

High growth expectations
Strong competitive position
Expanding market opportunity
Improving margins

Potential Negatives:

Overvalued and vulnerable to disappointment
Growth expectations may be unrealistic
Sensitive to interest rate changes
High valuation risk if execution falters

What to check:

What growth rate is implied?
Is that growth rate achievable?
What’s the company’s track record?
How sustainable is the competitive advantage?

Common P/E Pitfalls

1. Ignoring Earnings Quality

Not all earnings are created equal. Be cautious of:

One-time gains inflating earnings
Accounting tricks or aggressive revenue recognition
Unsustainable cost cutting
Share buybacks masking declining fundamentals

2. Comparing Across Different Growth Rates

A P/E of 30 might be cheap for a company growing 50% annually, but expensive for one growing 5%.

3. Negative Earnings

P/E ratios don’t work when earnings are negative. Companies losing money have no P/E ratio (or a meaningless negative one).

4. Cyclical Companies

For cyclical businesses (energy, materials, industrials), P/E ratios can be misleading:

Peak earnings = Low P/E (but may be a poor time to buy)
Trough earnings = High P/E (but may be a good time to buy)

PEG Ratio: P/E Adjusted for Growth

The PEG ratio addresses the growth rate limitation of P/E.

Formula: PEG = P/E Ratio / Annual EPS Growth Rate

Example

Company A: P/E of 20, growth rate of 10% = PEG of 2.0 Company B: P/E of 40, growth rate of 30% = PEG of 1.33

Despite Company B’s higher P/E, it has a better PEG ratio, suggesting better value when accounting for growth.

PEG Interpretation

PEG < 1: Potentially undervalued relative to growth
PEG = 1: Fair value (you’re paying a dollar of P/E for each percentage point of growth)
PEG > 2: Potentially overvalued relative to growth

PEG Limitations

Assumes growth rate is sustainable
Doesn’t account for earnings quality
Short-term growth rates may not continue
Ignores risk differences between companies

Comparing P/E Ratios

Effective Comparison Strategies

1. Historical Comparison

What’s the stock’s average P/E over the past 5-10 years?
Is the current P/E significantly higher or lower?
What caused deviations from the historical average?

2. Peer Comparison

How does the P/E compare to direct competitors?
Are differences justified by better growth, margins, or market position?
Is the entire sector trading at high or low valuations?

3. Market Comparison

How does it compare to the S&P 500 average (~15-20 historically)?
Are we in a high or low valuation environment overall?
What are interest rates (affects fair P/E levels)?

P/E Ratios and Market Conditions

Interest Rates Impact

Low interest rates: Support higher P/E ratios

Bonds are less attractive
Future earnings are worth more (lower discount rate)
Growth stocks particularly benefit

High interest rates: Pressure P/E ratios lower

Bonds become more competitive
Future earnings worth less (higher discount rate)
Value stocks often perform better

Economic Cycle Impact

Early cycle: P/E ratios may be high as earnings are depressed Mid cycle: P/E ratios normalize as earnings recover Late cycle: P/E ratios may compress as growth slows Recession: P/E ratios can spike as earnings collapse

Practical Application

Step-by-Step P/E Analysis

Find the P/E ratio: Check financial websites or Luna Capital’s stock analysis
Identify the type: Is it trailing or forward P/E?
Compare to industry peers: Find 3-5 comparable companies
Check historical range: Look at 5-year P/E history
Consider growth rate: Calculate PEG ratio if growth data available
Evaluate earnings quality: Review the actual financial statements
Factor in broader context: Interest rates, market conditions, sector trends
Make a judgment: Is the valuation reasonable given all factors?

Example Analysis

Company: Tech Stock XYZ

Current P/E: 35 (forward)
Industry average P/E: 28
Historical P/E range: 25-40
Growth rate: 25% annually
PEG: 1.4

Analysis:

Above industry average, but within historical range
PEG under 2 suggests growth rate supports valuation
Need to verify growth assumptions are realistic
Check if high P/E justified by competitive advantages
Consider if at high end of historical range poses risk

Integrating P/E Analysis with Luna Capital

Luna Capital’s AI analysis includes P/E ratios in context:

Automatic comparison to industry peers
Historical P/E trend analysis
Integration with other valuation metrics
Alerts when P/E reaches unusual levels
Insights into what’s driving P/E changes

Beyond P/E: Other Valuation Metrics

While P/E is important, use it alongside:

Price-to-Sales (P/S): Useful when earnings are negative or volatile
Price-to-Book (P/B): Important for financial and asset-heavy companies
EV/EBITDA: Better for comparing companies with different debt levels
Dividend Yield: For income-focused investors
Free Cash Flow Yield: Focuses on actual cash generation

Conclusion

The P/E ratio is a powerful tool, but it’s most effective when:

Used in proper context (industry, growth, market conditions)
Combined with other metrics
Adjusted for earnings quality
Compared across time and peers
Interpreted with business fundamentals in mind

Remember: A low P/E doesn’t automatically mean “buy” and a high P/E doesn’t always mean “sell.” The P/E ratio is a starting point for analysis, not the final answer.

Practice Exercise: Choose three stocks in the same industry. Compare their P/E ratios, growth rates, and calculate PEG ratios. Which appears to offer the best value? Why might the others trade at different valuations?

Next Step: Once comfortable with P/E analysis, explore our guide on “Understanding Stock Fundamentals” to build a comprehensive valuation framework.

How to Read P/E Ratios: A Beginner's Guide