# Demystifying the P/E Ratio: A CFO’s Simplified Guide to Smarter Investing”

*CNN just quoted my thoughts on one of the most essential financial metrics — the P/E ratio. As a Global CFO and NYU faculty member, I believe finance is often made unnecessarily complex. Here’s a simplified explanation of the P/E ratio. **Click here to read the CNN story**.*

As a Global CFO, I have visited all 193 countries in the world to enhance how we value stocks and evaluate the 100 M&As we assess annually. I also believe that financial concepts are often made unnecessarily complex, which is why I teach a graduate class at NYU to simplify these concepts.

**What is a P/E Ratio and Why Should Investors Know About It?** In simple terms, the P/E ratio shows how much we pay for an investment compared to how much money it generates. For example, a P/E ratio of 14 means we’re paying $14.00 for a share that earns $1.00. I’ll use this example to respond to all 7 questions. I like it because it’s simple to find or calculate, and it can be used when evaluating other investments.

**What are the P/E Ratio’s Ties to Stock Returns?** In the short term, stocks may be overpriced, trading at high ratios compared to earnings. However, this leads to a correction, with stock prices eventually dropping. The reason is straightforward: stocks are valued based on how much money they make; what accountants call earnings. When you buy a stock, you own a piece of the company and are entitled to a share of its earnings.

**How Can You Calculate a P/E Ratio?** To calculate the P/E ratio, divide the stock price, for example, $14, by its earnings per share, for example $1 per share, which gives you a P/E ratio of 14. This method can also be used to determine the value of a small business. If the P/E ratio for similar businesses is 14, a business earning $1 (million or billion) would be valued at $14 (million or billion).

**How should investors put the P/E ratio to work when investing in stocks? Also, what about P/E Ratios and Future Stock Returns? What should investors know here?**

Investors should look at historical P/E ratios in that industry, to evaluate whether stocks are expensive. The industry is critical, because different ones trade at different multiples. The challenge with Future Stock Returns is that it’s a guess, thus investors need to use caution.

**What Are the “Three Variants” of the P/E Ratio (Forward P/E, Trailing P/E, Hybrid P/E), and What Should Investors Know About Them?** The three variants of the P/E ratio are Forward P/E, Trailing P/E, and Hybrid P/E. I primarily focus on the Trailing P/E because the Forward P/E is speculative — I can’t be sure it will materialize. Similarly, when I buy a business, I pay for its current state. Any improvements made are for me, the buyer, to benefit from. However, in certain circumstances, a Forward P/E may be better. See my example below.

**How Should Investors Use the P/E Ratio When Investing in Stocks?** The argument for using the Forward P/E is that past performance doesn’t matter; the future is what counts. During the pandemic, healthcare clinics grew their revenue by 50%. When considering the purchase of such a business, it’s better to look at the forward ratio to estimate future earnings. The calculation is the same: divide the price by the estimated future earnings. For instance, if earnings are expected to decrease from $1 to $0.50, and the price is $14, the Forward P/E ratio is now 28 (14 divided by 0.50).

**What Does a Negative P/E Ratio Mean?** A negative P/E ratio indicates that the company is losing money. For example, a ratio of -14 might mean the price is 14, but earnings are -1.

**What is the PEG Ratio, What is a Good PEG Ratio, and How Does It Differ from the P/E Ratio?** The PEG ratio is important because it accounts for earnings growth. It’s calculated by taking the P/E ratio and dividing it by the earnings growth over the past 1–5 years. I prefer using a longer period, so I use 5 years and calculate the annual growth rate using the compounded annual growth rate (CAGR) formula. For example, if a stock sells for $14, earns $1, and its earnings have been growing by 3% per year, its PEG would be 14/3=4.7. Whether this is high depends on the industry. Generally, consumer products companies need to grow by more than 3% because inflation and population growth exceed 3%.