What is a P/E Ratio
The P/E ratio is a metric that assesses the relationship between a company's stock price and its earnings per share (EPS). It can be calculated based on both historical data (for trailing PE) or forward-looking estimates (for forward PE).
If a stock is trading at 20 EUR per share, for example, and its EPS are 2 EUR, then the P/E ratio of the stock would be 10 (20/2).
How to Analyze an Individual Stock Using the P/E Ratio
You may use the P/E ratio to gauge the valuation of a stock. A higher ratio indicates that a stock is relatively more expensive in relation to its earnings, while a lower ratio suggests that the stock is relatively less expensive.
However, determining "high" or "low" levels for a company's P/E ratio can be subjective. One effective approach is by:
Comparing company's current P/E in relation to its historical P/E range.
If appropriate, comparing the company's current P/E to that of similar companies at similar stages of maturity in the same business.
In this way, stocks can be classified as “growth” or “value” investments. An investment with an above average P/E ratio might be classified as a growth investment. An investment with a below average P/E ratio is typically classified as a value investment.
How to Analyze the Entire Market Using the P/E Ratio
We've talked about analyzing the P/E ratio of individual companies. But the same technique can be used to judge the valuation of entire stock market indices, such as the IBEX 35.
Investors can calculate the P/E ratio of the IBEX 35 by adding up the price of every stock in the index, and then dividing it by the sum of all IBEX 35 companies' EPS over the last 12 months (or their projected EPS over the next 12 months, in the case of forward P/E ratio).
The IBEX 35 has a long-term average P/E ratio of about 14. Higher P/E ratios can suggest an overvaluation of the index, whereas lower ratios may indicate an undervaluation of the index.
