P/E Ratio Explained: What It Tells You and Why a Low One Can Be a Trap

The price-to-earnings ratio is the most quoted number in investing, and one of the most misread. It seems simple: a low P/E means cheap, a high P/E means expensive. The real answer is more careful. This is Part 7 of our Read the Numbers series.

What it is

Investor.gov defines the P/E ratio as a way of gauging "whether the stock price is high or low compared to the past or to other companies." It's calculated by dividing the current stock price by earnings per share, where earnings per share is the past 12 months of earnings divided by common shares outstanding. FINRA puts it in plain terms: P/E tells you how much investors are paying for a dollar of a company's earnings.

Same price, very different stories

The ratio can't tell you which explanation is right. It tells you what the market is paying relative to earnings, and the rest is your analysis of why. FINRA stresses comparing with the market as a whole and with a company's own industry, since average P/E levels vary significantly across industries.

The low P/E trap

A low P/E looks like a discount. Sometimes it is one. But there are two common ways it misleads.

• The earnings are temporarily inflated. Say Company C's $6.00 includes a one-time $3.00 gain from selling a building. Strip it out and recurring earnings are $3.00, so the real P/E is 20, not 10. Always check whether earnings include one-time items; the income statement and notes show them.
• The earnings are about to fall. P/E uses past earnings. If Company C's earnings drop from $6.00 to $4.00 while the price stays at $60, the P/E rises from 10 to 15 without the stock moving. A low P/E on shrinking earnings is a warning, not a bargain.

When P/E doesn't work

• Negative earnings. A company losing money has no meaningful P/E.
• Cyclical businesses. Earnings can be unusually high at the top of a cycle (making P/E look low) or depressed at the bottom (making it look high).
• Backward-looking by design. The standard version uses trailing 12-month earnings. Many data providers also publish a forward P/E based on analysts' estimates, which is only as reliable as those estimates.
• Different accounting. Earnings depend on accounting choices, so comparing P/E across very different business models can mislead. This is why we look at cash flow alongside earnings.

P/E is a starting question, not an answer. A sensible next step is to check the trend in earnings, the cash flow behind them, and the balance sheet, which is exactly what the earlier parts of this series cover.

Common questions

What is a good P/E ratio?

There isn't one number. A P/E is best compared with the same company's history, similar companies in its industry, and the market as a whole. Growth companies often carry higher P/Es than mature, slower-growing ones.

Is a low P/E ratio a buy signal?

Not by itself. A low P/E can reflect earnings that are temporarily inflated or expected to fall. It's worth checking why the ratio is low and whether the earnings are sustainable before drawing conclusions.

How is the P/E ratio calculated?

Divide the current stock price by earnings per share. Earnings per share is the past 12 months of earnings divided by the number of common shares outstanding.