P/E Ratio Explained: Forward P/E, EPS and Market Cap, With Worked Examples

A $500 stock is not necessarily more expensive than a $50 stock. To know whether you are paying a lot or a little for a company, you have to compare its price with what the business actually earns. That is the job of the price-to-earnings ratio and a few related numbers.

This guide explains P/E, forward P/E, earnings per share and market capitalization in plain English, with clearly labeled hypothetical examples you can work through on a calculator. None of these numbers can tell you whether a stock will go up, but they can help you ask better questions.

What is the P/E ratio?

The price-to-earnings (P/E) ratio is a stock's share price divided by its earnings per share. It tells you how many dollars investors are paying for each $1 of a company's annual profit. A P/E of 20 means investors pay $20 for every $1 of earnings. Higher P/Es usually signal higher expectations for future growth.

The SEC's investor education site describes the P/E ratio as "a way of gauging whether the stock price is high or low" compared with the company's own past or with other companies. Investor.gov: P/E Ratio FINRA's example is simple: a $100 stock with earnings per share of $5 has a P/E of 20. FINRA: Financial Performance Metrics

Earnings per share: the building block

Earnings per share (EPS) is a company's net profit divided by its number of common shares. Investor.gov: Earnings Per Share FINRA's example: a company with $100 million of net income and 50 million shares has basic EPS of $2. Diluted EPS also counts shares that could be created from stock options, warrants and convertible securities, so it is typically a bit lower than basic EPS.

EPS can rise for two reasons: the company earns more, or it has fewer shares. When a company buys back its own stock, each remaining share represents a bigger slice of the profit. Schwab notes that buybacks can lower a stock's P/E by shrinking the share count. Our coverage of what a stock buyback means for everyday investors explains that trade-off in more detail.

Trailing P/E vs. forward P/E

The P/E you see quoted most often is the trailing P/E, which uses earnings from the past 12 months. Schwab describes it as backward-looking: it is based on actual results, but it can be distorted by one-time items or by earnings that swing with the economic cycle.

The forward P/E uses analysts' estimates of earnings for the next 12 months instead. It can be more useful for fast-growing or changing companies, but it depends on forecasts that can change and that may differ from one data provider to another. Schwab: What Is the P/E Ratio?