he pricetoearnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its pershare earnings (EPS). The pricetoearnings ratio is also sometimes known as the price multiple or the earnings multiple.

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The pricetoearnings ratio, or P/E ratio, helps you compare the price of a company’s stock to the earnings the company generates. This comparison helps you understand whether markets are overvaluing or undervaluing a stock.

The P/E ratio is a key tool to help you compare the valuations of individual stocks or entire stock indexes, such as the S&P 500. In this article, we’ll explore the P/E ratio in depth, learn how to calculate a P/E ratio, and understand how it can help you make sound investment decisions.

What Is the P/E Ratio?
The P/E ratio is derived by dividing the price of a stock by the stock’s earnings. Think of it this way: The market price of a stock tells you how much people are willing to pay to own the shares, but the P/E ratio tells you whether the price accurately reflects the company’s earnings potential, or it’s value over time.

If a company’s stock is trading at $100 per share, for example, and the company generates $4 per share in annual earnings, the P/E ratio of the company’s stock would be 25 (100 / 4). To put it another way, given the company’s current earnings, it would take 25 years of accumulated earnings to equal the cost of the investment.

In addition to stocks, the P/E ratio is calculated for entire stock indexes. For example, the P/E ratio of the S&P 500 currently stands at 28.61. Since prices fluctuate constantly, the P/E ratio of stocks and stock indexes never stand still. The P/E ratio also changes as companies report earnings, typically on a quarterly basis.

Three Variants of the P/E Ratio
While the math behind the P/E ratio is straightforward—price divided by earnings—there are several ways to factor the price or earnings used for the calculation.

The pricetoearnings ratio is most commonly calculated using the current price of a stock, although one can use an average price over a set period of time. When it comes to the earnings part of the calculation, however, there are three varying approaches to the P/E ratio, each of which tell you different things about a stock.

Trailing Twelve Month (TTM) Earnings
One way to calculate the P/E ratio is to use a company’s earnings over the past 12 months. This is referred to as the trailing P/E ratio, or trailing twelve month earnings (TTM). Factoring in past earnings has the benefit of using actual, reported data, and this approach is widely used in the evaluation of companies.

Many financial websites, such as Google Finance and Yahoo! Finance, use the trailing P/E ratio. Popular investment apps M1 Finance and Robinhood use TTM earnings as well. For example, each of these sites recently reported the P/E ratio of Apple at about 33 (as of early August 2020).

Forward Earnings
The pricetoearnings ratio can also be calculated using an estimate of a company’s future earnings. While the forward P/E ratio, as it’s called, doesn’t benefit from reported data, it has the benefit of using the best available information of how the market expects a company to perform over the coming year.

Morningstar uses this method, which it calls Consensus Forward PE. Using this method, Morningstar calculates Apple’s PE at about 28 (as of early August 2020).

The Shiller P/E Ratio
A third approach is to use average earnings over a period of time. The most well known example of this approach is the Shiller P/E ratio, also known as the CAP/E ratio (cyclically adjusted price earnings ratio).