Price to Earnings Ratio

P/E ratio (i.e. price to earnings ratio) is the ratio of a company’s current stock price to its earnings per share. By comparing P/E ratios, we can identify undervalued and overvalued stocks.

There are two variants of P/E ratio: (a) trailing P/E ratio, which is calculated by dividing current stock price by last year EPS and (a) forward P/E ratio, which is calculated by dividing the current stock price with expected next year EPS.

Price to earnings ratio tells us the dollars that must be invested in a company to earn one dollar each year. It measures how costly a stock is with reference to its ability to earn income. P/E ratio is compared across time and cross sectionally i.e. between different companies. When the P/E ratio of a company is higher than its competitors, there is a possibility that the stock might be overvalued and vice versa.

Trailing P/E ratio

Trailing P/E ratio is calculated by dividing the current stock price of a company by the last year earnings per share (EPS). It is the most common definition of price-to-earnings ratio. When we say just the P/E ratio, we mean the trailing P/E ratio.

Trailing P/E Ratio =P0

Where P0 is the current stock price and EPS0 is the last year annual earnings per share.

Forward P/E ratio

Forward P/E ratio is the price-to-earnings ratio variant which is calculated by dividing the current stock price by the earnings per share expected in the next 12 months.

Many investors and analysts prefer the forward P/E ratio because they believe that historical performance is not a particularly good indicator of future performance and that undervaluation or over-valuation of a stock should be determined by comparing its current price with earnings expected in future.

Forward P/E Ratio =P0

Where EPS1 is the earning per share expected in the next 12 months.

Justified P/E ratio

A justified P/E ratio is the price to earnings ratio which is justified by the company’s underlying fundamentals, i.e. growth rate and cost of equity, etc.

Justified P/E ratio can be determined by linking the P/E ratio with the Gordon growth model. Gordon growth model (GGM) is a single stage dividend discount model which determines a stock’s current stock as equal to the present value of a perpetuity comprising of the stock’s dividends. GGM equation is as follows:

P0 =D1
ke − g

Where P0 is the current stock price, D1 is the dividend per share next year, ke is the cost of equity and g is the growth rate.

Dividing both sides by E1, the earning per share expected next year, the left hand of the above equation equals the forward P/E ratio and the numerator of the right-hand side equals the dividend payout ratio (DPR):

P0= D1/EPS1= DPR
EPS1ke − gke − g

The above equation can be used to find out the P/E ratio indirectly based on the company’s dividend payout ratio, cost of equity and dividend growth rate. This P/E ratio is called the fundamental P/E ratio or justified P/E ratio.


Let us calculate the trailing P/E ratio and forward P/E ratio for Intel Corporation and compare it with its justified P/E ratio to see if the stock is overvalued or undervalued:

  • Current stock price is $54.51
  • Trailing twelve-month (TTM) earnings per share (EPS) is $1.99
  • EPS expected in next 12 months is $2.15
  • Dividend payout ratio is 48%, cost of equity is 9.5%% and growth rate is 7.6%

The trailing P/E ratio equals current stock price of $54.51 divided by last year EPS of $1.99. It works out to 27.31 (=$54.51/$1.99).

The forward P/E ratio (also called leading P/E ratio) equals P0 of $54.51 divided by next-year EPS (EPS1) of $2.15; it works out to 25.35 (=$54.51/$2.15)

The justified P/E ratio can be calculated as follows:

P0= DPR= 48%= 25
EPS1ke − g9.5% − 7.6%

Since the justified P/E ratio is close to the current forward P/E ratio, the stock seems to be fairly priced.

by Obaidullah Jan, ACA, CFA and last modified on is a free educational website; of students, by students, and for students. You are welcome to learn a range of topics from accounting, economics, finance and more. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect!

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