How to Value a Company Using Price to Earnings ratio

Most investors don’t rely on complicated models to decide whether a stock is worth buying. Instead, they often start with a few core metrics.

Put simply, the PE ratio tells you how much investors are willing to pay for each dollar of a company’s earnings. It’s calculated by dividing the current stock price by the company’s earnings per share (EPS).

Let’s say a stock is trading at $100 and its EPS is $5. That gives you a PE ratio of 20 — meaning investors are willing to pay 20 times the company’s earnings to own that stock.

But why should you care?

What counts as a ‘high’ or ‘low’ PE ratio isn’t one-size-fits-all — it really depends on the industry, the company’s stage of development and even broader macroeconomic trends. For example, what might be considered a high PE ratio for a slow-moving industrial firm could be completely normal — or even low — for a rapidly expanding software company. That’s why investors often avoid rigid thresholds and instead interpret PE ratios relative to a company’s peers or historical averages.

To make the concept more approachable, let’s first zoom in on growth stocks, which often trade at the higher end of the PE spectrum.

What is a growth stock?

Growth stocks are shares of companies expected to grow quickly and increase their profits faster than the market average. They attract investors looking for high potential returns, even though they can be riskier.

That’s because investors expect these companies to boost their earnings significantly over time, because they are expanding quickly, reinvesting heavily into their operations and prioritizing market share or innovation over short-term profits. These are often found in sectors like technology, biotech and consumer internet, where the potential for rapid revenue and earnings growth is high.

Because investors believe these companies will generate much higher profits in the future, they’re willing to pay a premium today. That premium shows up as a high PE ratio. In essence, a high PE in this context isn’t necessarily a warning sign — it’s a reflection of optimism.

If a tech company is trading at a PE of 50, that might seem steep compared to the market average, but it could be entirely reasonable if analysts expect the company’s earnings to double or triple in the next few years.

Sometimes, especially in earlier stages, these companies may not even have positive earnings yet — so their PE ratio is either extremely high or simply undefined. In such cases, investors shift their attention to other valuation metrics like price-to-sales (P/S) or forward PE, which uses estimated future earnings instead of trailing profits. Still, the principle is the same: the higher the growth expectations, the higher the valuation investors are typically willing to accept.

For those who believe in a company’s long-term vision, growth stocks with high PE ratios can be compelling opportunities.

Take Tesla for instance. It has a PE ratio of around 140 today — down from more than 1,000 in 2020! Investors are betting on big future gains, possibly driven by innovation in areas like autonomous vehicles and robo-taxis. The latter even helped the stock bounce back despite declining EV sales in 2024, but because Tesla is maturing, a PE ratio of 1000 would make less sense today than it did 5 years ago.

Or look at Nvidia. Its stock price has soared in recent years. Normally, a price surge would push the PE ratio higher, making the stock appear expensive. But Nvidia’s earnings surged at an impressive speed too, meaning its PE ratio didn’t balloon as much as expected. In this case, the rally was backed by fundamentals.

This is why considering valuations is critical: a rising stock price doesn’t always mean the stock is overvalued — especially if earnings are growing at the same pace.

What is a value stock?

Value stocks are shares of companies that are considered undervalued based on their current price compared to their intrinsic worth or earnings. They attract investors looking for bargains with steady growth potential, often with less risk than growth stocks.

These companies are often found in well-established sectors such as banking, energy, utilities, telecommunications and consumer staples. Rather than promising sky-high earnings in the distant future, value stocks are grounded in consistent cash flows, reliable dividends and proven operating histories.

This could be because they are in a less exciting industry, has faced recent headwinds, or simply doesn’t offer the same kind of growth narrative as a trendy tech firm. That doesn’t mean it’s a bad business — quite the opposite.

Let’s take Nestlé as an example. As a global food and beverage powerhouse with iconic brands like Nescafé, KitKat and Gerber, Nestlé operates in a sector known for defensive characteristics — meaning that people continue to buy its products in good times and bad. It’s a classic value stock: consistent earnings, strong dividend payouts and modest revenue growth year after year. Nestlé currently trades at a PE ratio around 20 — not exactly bargain-basement levels, but modest when compared with high-flying tech stocks.

Or consider ExxonMobil, one of the world’s largest oil and gas companies. It’s a giant in the energy sector with a long track record of profitability and cash generation. ExxonMobil tends to trade at a PE ratio in the range of 10 to 15, depending on where oil prices and investor sentiment sit. That lower PE reflects not just the maturity of the business, but also the cyclical nature of the energy industry and the perceived long-term risks related to the energy transition and regulatory pressures.

This calculates the average P/E ratio of all the companies within a stock market index, like the S&P 500. It reflects the market's overall valuation by dividing the total price of the index by the total earnings of its constituent companies over the past 12 months. This gives investors a sense of whether the index is overvalued or undervalued compared to historical norms or other markets.

The S&P 500’s average PE ratio typically hovers around 20. However, the index’s tech-heavy structure and the AI boom have pushed it closer to 30 in recent years. During the dot-com bubble, the ratio hit 38, while during the global financial crisis, it rose past the 120 level — on crumbling earnings.

In contrast, the European Stoxx 600 index has generally traded with a lower PE — around 13 historically, though it’s recently climbed to about 17. The constituants of the Stoxx 600 index are more cyclical and value plays — which explains the gap between the average PE ratio of the S&P500 and the Stoxx 600.

For investors, value stocks can be especially appealing during times of economic uncertainty or rising interest rates. Why? Because they offer tangible earnings today rather than the promise of future profits far down the line. In environments where capital becomes more expensive and discount rates rise, companies with steady cash flows and lower valuations tend to hold up better than speculative growth plays.

Additionally, value investing is often associated with a more contrarian approach — buying solid companies that are temporarily out of favor and waiting for the market to recognize their true worth. Legendary investors like Warren Buffett and Benjamin Graham built their fortunes on this philosophy, seeking companies that are fundamentally sound but trading at a discount to their intrinsic value.

They also tend to be more capital-efficient, meaning they often return a larger portion of profits to shareholders in the form of dividends or share buybacks, which can be especially attractive to long-term investors.

In short, those lower PE ratios seen in value stocks aren’t a sign of weakness — they’re a reflection of mature, dependable businesses that reward patient investors through solid, if unspectacular, performance over time.

In summary:

Above all, the price-to-earnings (PE) ratio serves as a crucial tool for investors trying to answer one of the most fundamental questions in the market: Is this stock fairly valued, overvalued, or undervalued? While it’s only one of many valuation metrics, the PE ratio offers a quick and accessible snapshot of how much the market is willing to pay for a company’s earnings. And when interpreted correctly, it can help highlight potential opportunities — or reveal hidden risks.

 You have to compare it to several benchmarks: the company’s past valuation history, the PE ratios of its sector peers, the broader market average and — crucially — expectations about future earnings growth.

For instance, if a company is trading at a PE of 12 while most competitors in the same industry are trading at 18 or 20, that discrepancy could point to an undervaluation. Maybe the market has unfairly punished the stock due to short-term noise or negative sentiment that’s unlikely to affect long-term fundamentals. In such cases, savvy investors may see a buying opportunity: a solid business temporarily on sale. Conversely, if a stock has a PE ratio of 50 while its peers are priced around 25, that could be a red flag. Unless there’s a compelling reason — like superior earnings growth, a disruptive product, or a dominant market position — the stock might be overpriced relative to its true earning power.

This type of comparative PE analysis is one of the most common ways investors try to spot mispriced securities. It’s not about finding the lowest PE ratio in the market or shunning high PE stocks altogether. Rather, it’s about understanding what the ratio is telling you in a specific context. A high PE might be justified for a cutting-edge biotech firm about to release a groundbreaking treatment. A low PE might be justified for a company in decline or facing serious legal risks.

Some investors also look at a company’s historical PE range. If a stock has historically traded between 15 and 20 times earnings and is now trading at 10, that could signal an opportunity — provided nothing fundamental has deteriorated. On the other hand, if a stock that typically trades at 25 is suddenly at 40, you need to ask: is the company growing faster than before? Has the competitive landscape changed? Or is the market simply getting carried away?

Another layer involves forward PE ratios, which use projected future earnings instead of trailing earnings. This forward-looking version of the PE ratio incorporates analyst forecasts and market expectations. If the forward PE is significantly lower than the current PE, it may signal that earnings are expected to rise rapidly. But if those expectations don’t materialize, the stock could end up correcting sharply. That’s why investors often compare both trailing and forward PE ratios side by side — to evaluate not just how the company is performing now, but how it’s expected to perform in the near future.

Sectors go through cycles, investor sentiment can swing wildly and macroeconomic factors like interest rates and inflation can change the way the market values future earnings. For example, in low-interest-rate environments, investors tend to tolerate higher PE ratios because future earnings are discounted less heavily. But when rates rise, those same earnings suddenly become less attractive and high-PE stocks often come under pressure.

The content in this article is provided for educational purposes only. It does not constitute investment advice, financial recommendations, or promotional material.