What Is a Good P/E Ratio?

There is no good P/E ratio. There is only a P/E that is justified by a particular set of growth, risk and durability assumptions -- and those assumptions are almost never stated by the person quoting the number.

What follows is how to work out the multiple a business deserves, and then how to tell whether the one it trades at is higher or lower than that.

Start with what the ratio means

Price divided by earnings per share. Or, identically, total market value divided by net income. The two forms explain why the number moves for reasons that have nothing to do with value: a share buyback shrinks the denominator, so the multiple falls without the business changing at all.

The inversion is more useful. Earnings yield is earnings divided by price -- the P/E turned upside down. A P/E of 20 is an earnings yield of 5%. That reframing lets you compare a stock against a bond, which is the comparison that actually disciplines the number.

The arithmetic of a justified multiple

In a business growing at a constant rate forever, the fair multiple is one divided by the spread between the return you require and the growth you expect:

Justified P/E = 1 / (required return - growth)

Require 9% and expect 4% growth, and the justified multiple is 1 / 0.05 = 20x. The formula is a simplification, but the sensitivity it exposes is real and it is the single most useful thing to understand about multiples:

One percentage point of growth is worth roughly 15% to 25% of the multiple. One point of required return, the same. This is why two analysts can look at identical financial statements and disagree about whether 18x is cheap.

Working it for Stetron

The site's running example earns $2.60 per share and trades at $37.60. That is a P/E of 14.5x, an earnings yield of 6.9%. Is it good?

Against the table above, a business with a 9% required return and 4% growth deserves about 20x. Stetron trades at 14.5x, a 27% discount. On those assumptions it looks cheap. But the discount is entirely a function of the growth assumption. Drop growth to 2% and the justified multiple is 14.3x -- Stetron is then trading at fair value, not at a discount.

The honest conclusion is not "cheap" or "expensive". It is: Stetron is priced for roughly 2% perpetual growth, and I need to decide whether I believe it will do better than that. That is a question about the business, and it is answerable. The reverse DCF calculator formalises exactly this: it solves for the growth rate implied by the current price, so the debate moves from opinions about multiples to a specific, falsifiable growth number.

Why sectors trade at different multiples, permanently

Multiples cluster by industry, and the clustering is not irrational. It reflects differences in growth, capital intensity and the durability of earnings.

These ranges are illustrative of long-run patterns rather than fixed rules, but the ordering is stable. A software company at 12x is a warning; a mining company at 30x is a forecast of peak earnings. The P/E ratio calculator will give you the multiple, the earnings yield, the PEG and a target price from an assumed exit multiple -- the judgement about which range applies is yours.

The four ways a low P/E lies

Peak-cycle earnings. A cyclical at the top of its cycle can show 6x earnings at the moment its earnings are about to halve. The low multiple is not a bargain, it is the market telling you the denominator is temporary. Check the multiple against mid-cycle rather than last-year earnings: recalculate it using the average earnings of the last seven to ten years. Deep cyclicals typically get cheaper on that basis at the top, and more expensive at the bottom.

One-off gains in the numerator. Selling a building produces an accounting profit with no operating value. Always check whether earnings include items the business will not repeat; a 9x multiple on inflated earnings can be 18x on the real thing.

Structural decline. The most expensive stocks in history have often looked statistically cheap. A business losing share to a cheaper substitute trades at a low multiple for years while the earnings slowly disappear. The test is not the multiple, it is whether revenue per unit of capital employed is holding or falling.

A denominator that is about to change. Forward P/E is calculated on consensus estimates, and consensus estimates are revised. A stock on 20x forward earnings is on 25x if estimates fall 20%. When you use forward multiples, ask how many analysts cover the stock and how wide the estimate range is. Two analysts with a wide spread is not consensus, it is a guess with a decimal point.

The earnings yield comparison that anchors everything

The most useful discipline is to always convert the multiple into an earnings yield and compare it against the risk-free rate. Stetron at 14.5x yields 6.9%. If the ten-year government bond yields 4.2%, you are being paid an extra 2.7 percentage points -- a spread of 1.64x -- for owning equity risk, cyclicality and the possibility that the earnings are simply not durable.

Whether that premium is enough is a judgement. What the arithmetic gives you is a way to notice when it is not there. When the earnings yield on a mature business falls below the government bond yield, you are being paid less than nothing for the risk, and no amount of optimism about growth fixes that.

Five questions that settle most of it

1. What growth rate does the current multiple imply, and is that rate plausible for this business?
2. Are the earnings in the denominator mid-cycle, peak, or trough? Recalculate on normalised earnings.
3. How much of the return on equity comes from leverage rather than the business?
4. Is the earnings yield comfortably above the risk-free rate, given the quality of the earnings?
5. What would have to be true for the multiple to be justified -- and can I state that in one sentence?

If you can answer the last one, you have a thesis. If you cannot, you have a chart, and a Graham number or an EPS figure will not turn it into one. Multiples are a language for expressing assumptions. Used without a sentence to go with them, they say nothing.

Frequently asked questions

What is a good P/E ratio?

A P/E is only meaningful next to the return on capital that produces the earnings. Stetron earns a 19.9% ROE on $2.60 of EPS and trades at $37.60, which is 14.5x. Kestrel earns an 11.0% ROE on $2.20 of EPS at $24.20, which is 11.0x. Kestrel has the lower multiple and earns roughly half as much per dollar of equity, so its earnings deserve a lower multiple. A good P/E is one you can tie to a return on capital that exceeds the cost of the money funding the position.

Is a low P/E ratio always a better buy?

No, and the Graham test run on this site's two companies shows exactly why. Stetron's P/E multiplied by its P/B is 41.8, above the 22.5 ceiling, so the formula rejects it. Kestrel's is 13.3, comfortably inside. The formula is instructing you to buy the company earning an 11.0% ROE over the one earning 19.9%. That is not an error in the arithmetic -- it is the formula's design. See the Graham number explained for the full working. A multiple is a price tag, not a verdict.

What P/E ratio is considered too high?

"Too high" describes a mismatch between the multiple and the return that funds it, not a number on a dial. Stetron's 14.5x is supportable because a 19.9% ROE comfortably exceeds the 9% cost of capital built from sourced inputs in the WACC guide. The same 14.5x on a business earning 6% would be pure growth pricing -- you would be paying today for earnings that may never arrive. The test is not the multiple; it is whether returns on capital can carry it.

Should you compare P/E ratios across different industries?

Only as a starting point, and never across different capital structures without adjusting. A leveraged company shows a lower P/E for identical operating performance, because equity carries the risk that debt has already claimed part of the cash flow. Cross-check against EV/EBITDA before drawing a conclusion. Within one industry the comparison is tighter -- Stetron at 14.5x against Kestrel at 11.0x -- but even there, most of the 3.5-turn gap is explained by the 8.9-point ROE difference rather than by mispricing.

Related guides

• How to Compare Two Stocks — A five-axis comparison, worked side by side, and why the cheaper multiple can be the dearer stock
• The Graham Number Explained — Graham's ceiling tested on two companies, and the three things it cannot see

More guides

• Dividend Yield vs Total Return — Four ten-year scenarios showing why a high yield and a high return are different things
• WACC Explained — The discount rate built from five sourced inputs, on the same worked example
• The DCF Method Explained — The forecast half of the model, worked end to end on one cash flow
• How to Value a Stock — The full valuation sequence on one worked example, from choosing a method to setting a buy price
• Free Cash Flow: What It Is and Why It Matters — The input every valuation depends on, including a case where profit is positive and cash flow is not
• Margin of Safety — How big a discount a given business deserves, and why a low multiple is not the same as a discount
• Dividend Investing — Testing whether a dividend is actually safe, using payout, cash coverage and leverage
• How to Read a Cash Flow Statement — The three sections, the eight sign combinations, and what each one warns you about
• Intrinsic Value vs Market Price — Why the two diverge, when cheap is not cheap, and what should force your estimate downward
• How to Read a Balance Sheet — Reading the asset side properly: six ratios, the ROE decomposition, and four common traps

Free valuation calculators

• DCF Calculator — fair value from five years of cash flow plus terminal value
• Dividend Discount Model — Gordon Growth valuation for dividend payers
• CAGR Calculator — compound growth rate and forward projections
• Dividend Yield Calculator — yield, income per $10,000, capital needed
• Payout Ratio Calculator — dividend safety and sustainable growth
• P/E Ratio Calculator — multiple, earnings yield, PEG, target price
• Graham Number Calculator — Graham's maximum buy price
• Total Return Calculator — price change plus dividends, annualized
• EV/EBITDA Calculator — enterprise value against operating earnings
• WACC Calculator — weighted average cost of capital for discounting
• Two-Stage DDM Calculator — high-growth then stable dividend valuation
• EPS Calculator — basic and diluted earnings per share
• P/B Ratio Calculator — price against book value, with ROE context
• Margin of Safety Calculator — discount between value and price
• Compound Interest Calculator — future value with periodic contributions
• Reverse DCF Calculator — the growth rate today's price already assumes
• DuPont ROE Calculator — break return on equity into its three drivers
• Position Size Calculator — how many shares to buy for a set risk