Value = Σ FCFₜ ÷ (1 + WACC)ᵗ + Terminal ValueRun the DCF backwards: ask what growth today's price assumes, then ask honestly whether reality can deliver it.
P/E Ratio (Price-to-Earnings)
The price you pay for each dollar of a company's annual earnings — investing's most used number, and possibly its most misused.
What is the P/E ratio?
The price-to-earnings (P/E) ratio is a company's share price divided by its earnings per share — the price you pay for each dollar of annual earnings. A P/E of 15 means $15 per $1 of earnings, an earnings yield of about 6.7%. Every P/E is really a compressed forecast: a high multiple assumes durable growth, a low one assumes stagnation or decline.
- Trailing P/E uses the last 12 months of earnings; forward P/E uses analyst forecasts.
- A low P/E does not mean cheap — it can signal a value trap with deteriorating earnings.
- It is a fast first filter and a starting question, never a conclusion on its own.
Definition
The P/E ratio divides a company's share price by its earnings per share. A P/E of 15 means you pay $15 for every $1 of current annual earnings — equivalently, an "earnings yield" of about 6.7%.
Variants matter: trailing P/E uses the last twelve months of actual earnings; forward P/E uses analyst forecasts. The same company can show very different numbers depending on which "E" is chosen and whether one-time items distort it.
Why it matters
The P/E compresses a full valuation into one comparable number, which makes it a fast first filter across companies and against a stock's own history. Implicitly, every P/E is a compressed DCF: a high multiple assumes strong, durable growth; a low one assumes stagnation or decline. Reading the assumption inside the number is the skill.
Simple example
Two companies each earn $1 per share. One grows earnings 15% annually with high returns on capital; the market prices it at a P/E of 30. The other is shrinking 5% a year; it trades at a P/E of 7. Neither number is a mistake — they are forecasts in disguise. The question is never "which P/E is lower?" but "which forecast is wrong?"
Common misconception
"A low P/E means a stock is cheap." Sometimes — and sometimes it means earnings are about to fall, the business is in decline, or the "E" is inflated by one-time gains. This is the value trap: statistically cheap, fundamentally deteriorating. A P/E is a starting question, never a conclusion.
- 1Trailing P/E uses the last 12 months of earnings; forward P/E uses analyst forecasts.
- 2A low P/E does not mean cheap — it can signal a value trap with deteriorating earnings.
- 3It is a fast first filter and a starting question, never a conclusion on its own.
| Shortcut | The price you pay for each dollar of a company's annual earnings — investing's most used number, and possibly its most misused. |
|---|---|
| Disciplined workflow | Trailing P/E uses the last 12 months of earnings; forward P/E uses analyst forecasts. → A low P/E does not mean cheap — it can signal a value trap with deteriorating earnings. → It is a fast first filter and a starting question, never a conclusion on its own. |
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True story · The Nifty Fifty, 1972
When the price already assumed a miracle
In 1972, institutions convinced themselves that about fifty "one-decision" growth stocks could be bought at any price and never sold. Polaroid traded above 90 times earnings, McDonald's and Disney near 80, Avon around 65. Run the arithmetic backwards and those prices quietly assumed decades of flawless, ever-accelerating growth.
The 1973–74 bear market repriced the dream: the group fell 60–90%, and Polaroid eventually went bankrupt. The cruel detail is that many of the businesses kept growing exactly as promised — the investments still failed, because the starting price had already spent the future.
Run the DCF backwards: ask what growth today's price assumes, then ask honestly whether reality can deliver it.
90×Polaroid's P/E at the top
−60–90%drawdown in 1973–74
10+ yrsto recover, if ever
True story · Berkshire & Apple, 2016
A quality compounder hiding in plain sight
In 2016, with Apple trading near 10–12 times earnings amid fears the iPhone cycle had peaked, Berkshire began buying — eventually about $36 billion of stock. Buffett's thesis required no technology forecast: a product customers would not abandon, extraordinary returns on invested capital, and a buyback machine that increased Berkshire's ownership share every year without another dollar spent.
The stake grew to be worth more than $150 billion at its peak — the most profitable single investment in Berkshire's history, earned not by predicting gadgets but by recognizing a high-ROIC franchise priced like a metal-bender.
High returns on capital plus a shrinking share count quietly multiply your slice of the profits.
≈$36Binvested from 2016
$150B+peak value of the stake
10–12×starting P/E
True story · Graham's net-nets
Buying a dollar for fifty cents — by the basket
Graham's signature operation was mechanical and unglamorous: buy companies trading below their "net-net" working capital — cash, receivables and inventory minus every liability — so the buyer effectively paid nothing for the factories, the brand or the future. Each one was a discarded cigar butt with one free puff left.
Any single net-net could disappoint, so Graham never relied on one: Graham-Newman held dozens at a time, selling each as it returned to fair value. Across three decades, through depression aftermath and war, the diversified baskets earned roughly 20% a year — built from stocks nobody else wanted.
A screen's edge comes from discipline and diversification across the basket — not from any single thrilling pick.
≈20%/yrreturns over decades
dozensheld at any one time
30 yrsof repeatable evidence
Related tools
Frequently asked questions
What is a "normal" P/E?
Long-run market averages sit roughly in the mid-to-high teens, but normal varies hugely by industry, growth, and interest rates. Compare to a company's own history and peers, not a universal yardstick.
Why do some great companies always look expensive on P/E?
Because the ratio penalizes current earnings depressed by heavy reinvestment. Companies investing through the income statement can have understated "E" — one reason analysts cross-check with cash flow measures.
Go beyond ratios with guided valuation workflows:
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