P/E and PEG Ratio Deep Dive#

The Price-to-Earnings ratio is the world's most popular valuation metric—and also one of the most misused. Understanding its nuances separates sophisticated investors from those who blindly chase "low P/E" stocks.

Trailing vs. Forward P/E#

Not all P/E ratios are created equal. The two main variants tell different stories.

Trailing P/E (TTM)#

Uses the last 12 months of actual, reported earnings.

Forward P/E#

Uses analyst estimates of next 12 months' earnings.

Example: Reading Both Together#

Both stocks have identical trailing P/E of 20x. But:

• Stock A: Analysts expect earnings to decline 20% (Forward P/E higher)
• Stock B: Analysts expect earnings to grow 30% (Forward P/E lower)

Stock B is the better value if estimates are accurate.

Sector P/E Ranges#

Different industries trade at structurally different P/E levels based on growth, risk, and capital intensity.

Why the Differences?#

High P/E sectors share characteristics:

• Higher expected growth rates
• Asset-light business models
• Lower capital requirements
• More predictable revenue

Low P/E sectors typically have:

• Cyclical or commodity-linked revenues
• Heavy capital requirements
• Regulatory constraints
• Lower growth ceilings

Market Cycle Impact#

Overall market P/E expands and contracts with the economic cycle:

Historical Context: The S&P 500's long-term average P/E is about 16-17x. But it has ranged from 7x (1982 bear market) to 44x (2000 dot-com bubble).

The Growth Problem: Enter PEG#

P/E's biggest limitation: it ignores growth. A 30x P/E might be cheap for a 40% grower but expensive for a 5% grower.

PEG Ratio Solution#

PEG Interpretation#

PEG Example#

FastGrow's 40x P/E looks expensive, but its PEG of 1.0 is actually the most attractive. SlowStable's "cheap" 12x P/E is actually the most expensive growth-adjusted.

PEG Limitations#

Don't use PEG blindly:

1. Which growth rate? Historical? Forecast? 1-year? 5-year?
2. Growth estimates can be wrong — especially for volatile companies
3. Assumes linear P/E-to-growth relationship — reality is more complex
4. Doesn't work for declining companies — negative growth breaks the math
5. Ignores profitability quality — two 15% growers may have very different margin profiles

When P/E Fails#

1. Negative Earnings#

P/E is meaningless for unprofitable companies. Alternatives:

• P/S (Price/Sales) for revenue-generating but unprofitable firms
• EV/Revenue for enterprise-level comparison
• P/FCF for cash-generating firms with accounting losses

2. Cyclical Peaks and Troughs#

At a cycle peak, earnings are high, making P/E look low—just when you should be cautious.

Example: Steel Company

• Peak earnings: EPS of $8, P/E of 5x (looks cheap!)
• Trough earnings: EPS of $1, P/E of 40x (looks expensive!)

Sophisticated investors use normalized P/E (average earnings across the cycle) for cyclical companies.

3. Earnings Manipulation#

Accounting choices affect reported earnings:

• Depreciation methods
• Revenue recognition timing
• Restructuring charges
• Stock compensation treatment

Example: "Adjusted EPS" excludes stock-based compensation. A tech company might report:

• GAAP EPS: $2.00 → P/E of 50x
• Adjusted EPS: $3.50 → P/E of 29x

Which is "right"? Both have merit, but make sure you're comparing apples to apples.

4. Capital Structure Differences#

P/E doesn't account for debt. Two companies with identical P/E:

• Company A: No debt
• Company B: Heavy debt

Company B is riskier, so the same P/E represents worse value. Use EV-based multiples (EV/EBIT, EV/EBITDA) for leverage-neutral comparison.

Advanced P/E Analysis#

CAPE (Cyclically Adjusted P/E)#

Also called "Shiller P/E" after economist Robert Shiller:

CAPE = Price / Average of 10 Years' Inflation-Adjusted Earnings

Smooths cycle effects and is useful for market-level valuation. The S&P 500's historical CAPE average is ~17x. Current CAPE levels above 30x historically precede lower future returns.

Relative P/E#

Compare a stock's P/E to its sector or the market:

Relative P/E = Stock P/E / Market P/E

Track relative P/E over time to see if the premium/discount is normal for this company or represents an opportunity.