What Is the P/E Ratio and How to Use It

The price-to-earnings ratio is the most widely used valuation metric in investing, and understanding it deeply gives you a powerful tool for evaluating whether a stock is cheap or expensive relative to its earnings. But like any single metric, it can mislead as easily as it can inform.

The P/E ratio is simply the stock price divided by earnings per share. A stock trading at $100 with $5 of earnings per share has a P/E of 20. This means investors are paying $20 for every $1 of current earnings. You can think of the P/E as the number of years it would take to earn back your investment through current earnings, assuming earnings remain constant.

Benjamin Graham considered the P/E ratio one of the most important screening tools for value investors. He recommended buying stocks with P/E ratios below 15 for average companies and below 10 for companies facing temporary difficulties. Graham's "earnings yield" approach -- inverting the P/E ratio -- made the comparison to bond yields straightforward. A stock with a P/E of 15 has an earnings yield of 6.7%, which can be directly compared to bond yields.

Warren Buffett uses P/E as a starting point but emphasizes that a low P/E alone does not make a stock cheap. A company with a P/E of 8 might be expensive if its earnings are about to collapse, while a company with a P/E of 25 might be cheap if its earnings are growing at 20% annually. The P/E ratio tells you what you are paying for current earnings, but it says nothing about the quality or durability of those earnings.

Charlie Munger warns against "P/E worship" -- the tendency to buy stocks solely because they have low P/E ratios. Many low-P/E stocks are cheap for good reasons: declining businesses, management problems, structural industry changes. These "value traps" look statistically cheap but destroy capital. A truly cheap stock has a low P/E AND high-quality earnings that are stable or growing.

The most useful P/E comparison is relative rather than absolute. Compare a company's P/E to its own historical average, to its industry peers, and to the overall market. A stock trading at 15x earnings when its historical average is 25x and its peers trade at 20x may represent genuine value. A stock at 15x when its historical average is 10x and peers trade at 8x is actually expensive.

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The Bottom Line

The P/E ratio is like a thermometer -- it tells you the temperature but not the diagnosis. Use it as one input among many in your investment analysis.