PE Ratio: Compare Relative Values

PE Ratio (Price-to-Earnings) is a valuation ratio that compares the price per share of a company’s stock to its earnings per share.

It basically shows how much investors are willing to pay for a share given the earnings currently generated.

It is also used to analyze whether a stock is overvalued or undervalued.


How to use the PE Ratio:

  • The PE Ratio by itself is just a number and not very useful.
  • When we compare PE ratios between companies and industries, we really start getting the picture for the particular company we are analyzing.
  • It does not make much sense to compare PE Ratios of companies across different industries, as each industry has its own unique way of conducting business.
  • It’s like comparing a doctor with an engineer to see which one is more valuable.
  • Hence, if comparing PE ratios, they should be compared between companies in the same or similar industries.
  • You can also compare the PE ratio of a company to the PE Ratio of the entire industry that it operates in to analyze whether the stock is over or under-valued.


How to interpret the PE Ratio

High P/E Ratio may mean:

  1. Market sentiment: An overly optimistic PE Ratio can indicate the market expects big things from this company. The company has high growth possibilities.
  2. Lifecycle: The company could be entering into the Growth or Shake-Out stage of its lifecycle.
  3. Industry: A PE Ratio could be representative of the industry the company is. For example most technology companies have high PE Ratios.
  4. Cover priced or over-bought: A high PE Ratio can indicate a given stock is priced to high and ready for a correction.
  • This means that it might be over-valued.
  • Be sure to compare against industry norms.


Low P/E Ratio may mean:

  1. Lack of confidence: A low PE Ratio may indicate a lack of confidence in the future of the company.
  2. Lifecycle: The company could be in the Mature or Decline stage of its lifecycle.
  3. Industry: A PE Ratio could be representative of the industry the company is. For example most utility companies have low PE Ratios.
  4. Sleeper: A low PE Ratio might be a sleeper just waiting to be discovered. This means that it might be undervalued, and a perfect time to start buying the shares.



Coca-Cola and Pepsi operate in the same industry and produce goods that are very similar in nature.

  • Coca Cola’s (KO:NYSE) stock price (Price per Share): $66
  • Coca-Cola’s Earnings-per share (EPS): $5.26
  • Coca-Cola’s PE Ratio: $66 / $5.26 = 12.55


  • Pepsi’s (PEP:NYSE) stock price (Price per Share): $69
  • Pepsi’s Earnings-per share (EPS): $3.73
  • Pepsi’s PE Ratio: ($66 / $5.26) = 18.50

From our calculations, we can see that Pepsi has a higher PE Ratio than Coca-Cola.

This could be perceived a couple of different ways:

  • Coca-Cola is under-valued and should be bought.
  • Pepsi is over-valued and should be sold or shorted.
  • Investors do not perceive Coca-Cola as doing as well as Pepsi presently.
  • Pepsi is launching a new product that Coca-Cola is not.

The truth is normally some combination of these perceptions.

Over time, and with additional research, one can potentially pinpoint the exact occurrence and make a lot of money by trading according to his or her analysis.

*Important Note*:

  • The Earnings-Per-Share in the PE Ratio formula is a number that comes from the accounting books of the company.
  • Hence, it is possible to manipulate the EPS underlying the PE Ratio in order to trick investors into perceiving the stock differently.
  • It is important to independently verify that the company’s’ financial statements are sound and true.



A PE Ratio is an important valuation tool that can give key insights into whether a stock may be over or under-valued.