How to calculate the price-to-earnings ratio and the earnings yield, and how to turn any P/E into the growth rate the price is assuming.
No P/E ratio is good or bad on its own: the price-to-earnings ratio is price divided by earnings per share, and what it tells you is how much growth the price already assumes. With an illustrative 8 per cent required return and half of earnings paid out, a forward P/E of 15 assumes earnings grow 4.67 per cent a year for ever, and a P/E of 25 assumes 6.00 per cent. A good P/E is one whose implied growth the business can actually deliver.
Worked in full in Stock Market Investing for Beginners by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Take an illustrative company whose shares trade at 150. It earned 6.00 a share over the last twelve months and analysts expect 6.36 over the next twelve, growth of 6.0 per cent.
| Measure | Value |
|---|---|
| Share price | 150 |
| Earnings per share, last twelve months | 6.00 |
| Earnings per share, next twelve months | 6.36 |
| Trailing P/E | 25.0 |
| Forward P/E | 23.58 |
| Earnings yield, trailing | 4.00% |
P/E = share price / earnings per share
Earnings yield = earnings per share / share price = 1 / P/E
Implied growth g = required return − payout ratio / forward P/E
In Excel, required return in B1, payout B2, forward P/E B3: =B1-B2/B3
150 / 6.00 = 25.0 on trailing earnings; 150 / 6.36 = 23.58 on forward earnings. The earnings yield is the same ratio upside down: 6.00 / 150 = 4.00 per cent. For a whole market or an index fund the calculation is identical, using the index level and the index's earnings, which fund providers publish.
A share is worth the dividends it will pay, discounted at the return you require. If dividends grow at a steady rate g, the price is next year's dividend divided by (r − g). Dividing both sides by next year's earnings gives forward P/E = payout ratio / (r − g), which rearranges into the implied growth formula in the panel.
With r of 8 per cent and a payout of 50 per cent, the forward P/E of 23.58 implies g = 8% − 0.50 / 23.58 = 5.88 per cent a year. That is close to the 6.0 per cent expected next year, but the formula asks for it every year, indefinitely. The required return and payout are illustrative: change them and the implied growth changes, which is the point of writing them down.
| Forward P/E | Earnings yield | Dividend yield | Implied growth |
|---|---|---|---|
| 15 | 6.67% | 3.33% | 4.67% |
| 25 | 4.00% | 2.00% | 6.00% |
| 40 | 2.50% | 1.25% | 6.75% |
The relationship is far from linear. Going from 15 to 25 times earnings adds 1.33 points of implied growth; going from 25 to 40 adds only 0.75. Read the other way round, small changes in the growth you believe produce very large changes in the P/E you can justify:
| Growth a year | Justified P/E |
|---|---|
| 3% | 10.0 |
| 4% | 12.5 |
| 5% | 16.7 |
| 6% | 25.0 |
| 7% | 50.0 |
One extra point of permanent growth, from 6 to 7 per cent, doubles the justified P/E. The required return matters as much: at 7.5 per cent and 6 per cent growth the justified P/E is 33.3, at 8.5 per cent it is 20.0. That is why high-P/E shares fall so hard when growth disappoints or interest rates rise: the price was sitting on the steep part of the curve.
A P/E is also the number of years of today's earnings it takes to earn back the price. With no growth, 15 times takes 15 years, 25 times takes 25 years and 40 times takes 40 years. If earnings grow 6 per cent a year, the payback shortens to 12, 16 and 22 years. It is a crude measure, since earnings are not cash in your hands, but it makes the scale of a high multiple concrete.
Mixing trailing and forward P/E. The same share is on 25.0 times trailing and 23.6 times forward earnings. Comparing one company's forward P/E with another's trailing figure creates a gap of 1.4 turns out of nothing.
Comparing P/E ratios across very different businesses. A slow-growing utility on 15 and a fast-growing software company on 40 may both be fairly priced, or both expensive; the implied growth, not the multiple, is the comparison.
Trusting a P/E built on unusual earnings. A one-off gain makes the P/E look low; a one-off loss makes it look absurdly high or negative. Check that the earnings are repeatable before reading anything into the ratio.
For a beginner buying a broad index fund, the market P/E is a guide to expectations, not a timing signal. A high market P/E implies a low earnings yield and therefore lower long-run returns from today's price, but it says nothing about next year.
Stock Market Investing for Beginners argues for owning the whole market cheaply rather than picking shares on multiples; the free workbook for the book shows what compounding and costs do to that approach over a working life. The dividend half of the return is worked in how much reinvested dividends add.
Divide the share price by earnings per share. A share at 150 with 6.00 of earnings over the last twelve months has a trailing P/E of 25.0; with 6.36 of expected earnings for the next twelve months its forward P/E is 23.58. Always state which earnings you used, because the two can differ by more than a full turn.
No. A low P/E is cheap only if the earnings hold up. At an 8 per cent required return and a 50 per cent payout, a P/E of 15 implies earnings growth of 4.67 per cent a year; if the business is shrinking, even 15 is expensive. A high P/E can be fair for a company that really can grow at 6 or 7 per cent for decades.
The inverse of the P/E: earnings per share divided by price. A P/E of 25 is an earnings yield of 4.00 per cent, a P/E of 40 is 2.50 per cent. It is a rough guide to the long-run return from today's price for a company whose earnings are not expected to grow, and easier to compare with a bond or savings rate than the P/E itself.
This article is one calculation from Stock Market Investing for Beginners. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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