If you are exploring valuation metrics or doing financial modelling as part of your skillset, then the PE Ratio is one of those foundational building blocks you simply can’t skip.
What Is the P/E Ratio?
The price-to-earnings ratio, usually just called the P/E ratio gives a quick sense of how expensive a stock might be. You arrive at it by taking the market price of a share and dividing it by the company’s earnings per share (EPS).
However, there are variations in how “earnings” are defined (adjusted, normalized, excluding one-time gains or losses), and whether one uses historical or projected earnings.
Why Does the P/E Ratio Matter?
Investors like the P/E ratio because it’s a quick way of checking how expensive a stock looks compared to the money it actually earns. But a high P/E doesn’t automatically mean the stock is “bad.” Sometimes it just reflects the fact that investors expect the company to grow fast. On the flip side, a low P/E isn’t always a bargain
Even comparing two companies side by side isn’t always straightforward. If one has a P/E of 30 and other sits at 15, you can’t immediately call the cheaper one undervalued. Maybe the first company has cleaner balance sheets or better growth prospects. Context matters a lot.
Some investors even flip the P/E ratio upside down into what’s called an earnings yield (earnings divided by price). That number can be compared directly with bond yields or fixed-income returns, which sometimes makes the decision easier for income-focused investors.
Limitations
Even though the P/E ratio gets quoted everywhere, it does come with a few limitations
- Negative or zero earnings: When a company is making losses, the P/E cannot be computed. That’s why most stock screeners will just show “N/A” or a dash in such cases.
- Quality of earnings: Profits aren’t always clean. One-time items, accounting tweaks, or just the ups and downs of a business cycle can distort earnings. That means a high or low P/E might not tell the whole story.
- Growth Factors: The ratio itself doesn’t include growth. Two firms can both trade at 15× earnings, but if one is growing fast and the other is stagnant, the numbers don’t really compare. This is where the PEG ratio (P/E divided by growth) becomes handy.
- Industry differences matter: What looks like a “cheap” P/E in one sector may be considered high in another. Utilities and biotech, for example, live in totally different worlds when it comes to typical multiples.
- Debt isn’t reflected: P/E only looks at equity earnings. So, if two companies earn the same per share but one has heavy debt and the other is debt-free, their valuations shouldn’t be judged equally. That’s why investors often also check EBITDA.
- Market mood counts too: Things like interest rates, inflation or even just investor sentiment push P/Es up and down across the market. Comparing with historical averages or benchmarks gives better context.
Importance in Investment Banking
If you are a banking professional or aiming for a career in investment banking, mastery over valuation multiples like P/E is essential.
- When doing comparable company analysis (comps), P/E is often one of the first multiples you compare across peers.
- If you advise clients, stakeholders will expect you to interpret whether a stock or sector is “rich” or “cheap” relative to P/E norms.
- In investment banking courses, students often practice building valuation cases where they compute P/E, EV/EBITDA, P/B, and triangulate to derive a valuation range.
- In many courses for banking professionals, P/E is among the first ratio topics taught, given its intuitive appeal and wide use in markets.
One specific entity in the training sphere is FinX. FinX offers financial modelling & equity research programs and often includes modules on valuation multiples including P/E. By learning from such structured curricula, you get guided practice on P/E in realistic case studies, not just textbook definitions.
Where P/E Fits in a Valuation Toolkit
In a well-rounded valuation or modeling curriculum, you won’t stop at P/E. You’ll also use:
- EV/EBITDA, EV/EBIT (which adjust for capital structure)
- Price-to-Book (P/B) for asset-intensive firms
- PEG ratio to incorporate growth
- Discounted Cash Flow (DCF) to project free cash flows and discount them
P/E remains useful because it’s intuitive, widely available, and frequently quoted in financial media and stock screeners.
A Few Additional Tips & Nuances
- Always compare P/E within industry peers, not across wildly different sectors.
- Watch out for one-off items: nonrecurring gains or losses distort EPS and hence P/E.
- Use normalized or adjusted earnings where possible.
- Be careful when earnings are negative — P/E becomes misleading.
- Trend the P/E over time to see whether it is expanding or compressing for a company.
- Keep context in mind (interest rates, macro, sentiment).
