You find a stock trading at ₦500 and another at ₦2,000. Which one is cheaper? If you judge by share price alone, the answer seems obvious. But what if the ₦500 stock is actually more expensive relative to the profits its company earns? One of the most useful tools for finding out is the price-to-earnings (P/E) ratio.
In this guide, you will learn how to use the P/E ratio to identify potentially overvalued and undervalued stocks, understand trailing versus forward P/E, and avoid the value traps that catch inexperienced investors. Whether you invest in Nigerian stocks or international markets, you will learn how to look beyond cheap-looking prices and make more informed investment decisions. If you are new to the Nigerian stock market, start with this guide on investing in Nigerian stocks.
What is the P/E ratio?
The price-to-earnings ratio, or P/E ratio, compares a company’s share price with its earnings per share (EPS). P/E ratio = share price ÷ EPS.
For example, if a share costs $120 and the company earns $5 per share, its P/E ratio is 24. That means investors are paying $24 for each $1 the company earned per share over the period measured.
A high P/E may mean investors expect the company’s earnings to grow. A low P/E may mean they expect slower growth or see more risk, but the ratio alone cannot tell you why.
Trailing P/E vs. forward P/E
Trailing P/E uses a company’s earnings from the past 12 months. Because it is based on reported results, it shows what the company has already earned.
Forward P/E uses estimates of what the company may earn over the next 12 months. It can help you judge how investors view future growth, but estimates can be wrong.
Compare both ratios to see how expectations affect a stock’s valuation. For example, a lower forward P/E may suggest investors expect earnings to rise, but you should check whether those estimates are realistic.
How to tell if a stock is overvalued or undervalued
There is no single P/E ratio that makes every stock overvalued or undervalued. To judge a stock’s value, compare its P/E with similar companies and consider what the business is expected to earn.
Start with direct competitors in the same industry. A P/E of 30 might be reasonable for a fast-growing company if similar businesses have higher ratios, but expensive for a slower-growing company whose peers have lower ratios. Differences in growth, risk, and how a business makes money can explain why companies have different P/E ratios.
Next, compare the stock’s current P/E with its own past range, such as its average over five years. A higher ratio than usual could mean investors expect faster growth or see less risk than before. A lower ratio could point to a cheaper price, but check whether the company’s earnings or outlook have weakened.
You can also compare the stock with the broader market, such as the S&P 500. That gives you general context, but it does not tell you whether one company is fairly priced. If you include a current market figure, check a reliable source and state the date because P/E ratios change over time.
A high P/E may signal that investors expect strong growth, while a low P/E may reflect slower growth or greater risk. For example, a growing technology company and a mature utility could have the same P/E, yet their outlooks and risks may be very different. Before deciding whether a stock is overvalued or undervalued, ask what explains its P/E compared with its peers and its own history.
For Nigerian investors, this comparison can be useful when assessing established companies. You can research individual shares such as MTN Nigeria and Dangote Cement, then compare their earnings, growth prospects, risks, and valuations with those of relevant competitors.
Using the PEG ratio for better context
The price-to-earnings growth (PEG) ratio adds expected earnings growth to a P/E comparison. A common formula is PEG ratio = P/E ratio ÷ expected annual earnings growth rate. For example, a P/E of 20 and expected annual growth of 20% gives a PEG of 1.
Investors often treat a PEG near 1 as a rough reference point. A lower PEG may mean the share price is modest compared with expected growth, while a PEG above 1.5 or 2 may suggest a higher price. These are only rules of thumb: growth estimates can be wrong, so use the PEG ratio alongside other measures.
Limitations of the P/E ratio
The P/E ratio can give a misleading picture when earnings are unusual. A one-time gain can make profits look higher, while a loss or a share buyback can change earnings per share; during economic ups and downs, a company’s profits may also rise or fall sharply. If earnings are zero or negative, the ratio is not useful.
P/E also leaves out important details, such as debt, cash flow, and the strength of a company’s business. To get a fuller picture, compare it with other measures, such as EV/EBITDA, price-to-book for asset-heavy companies, or free-cash-flow yield, and review the company’s financial health. Learn how to examine these details in our guide on reading company financial statements.
Practical step
To judge a stock’s P/E ratio, check both trailing and forward figures. Compare them with similar companies and the stock’s past range, then review the earnings growth the price may assume. Look into the reasons for any large difference.
Use P/E as a starting point, not a final verdict. Combine it with other financial measures and research the company before deciding what its valuation may mean. You can also compare valuation with other investment characteristics when researching Nigerian blue-chip stocks, rather than choosing a share based on its price or P/E ratio alone.
Popular questions on P/E ratio and stock valuation
1. How to tell if a stock is overvalued or undervalued?
Compare the stock’s trailing and forward P/E ratios to three benchmarks: (1) direct industry peers and the sector average, (2) the company’s own five-year historical average, and (3) the broader market. A P/E significantly higher than these benchmarks without superior growth or quality often signals overvaluation. A meaningfully lower P/E with stable or improving fundamentals may indicate undervaluation. Always check the PEG ratio (P/E ÷ expected growth rate) and supporting metrics such as EV/EBITDA, free-cash-flow yield, and debt levels. Context and the “why” behind the multiple matter more than the number itself.
2. How can I tell if the stock market is overvalued or undervalued?
Look at multiple long-term indicators rather than a single snapshot. Common measures include the S&P 500 trailing and forward P/E, the CAPE (cyclically adjusted P/E or P/E10), the Buffett Indicator (total market capitalization relative to GDP), and the Q ratio. As of September–October 2026, several of these indicators (including average readings showing 120–214% overvaluation relative to historical means) place the S&P 500 in overvalued territory by historical standards, though elevated valuations can persist for extended periods.
3. At what PE ratio is a stock overvalued?
There is no fixed cutoff. A P/E of 25 may be reasonable for a high-growth technology company and expensive for a mature utility. Extremely elevated multiples (for example, above 50–100 without clear justification from rapid earnings growth) raise the risk of overvaluation because they leave little room for disappointment. Always judge relative to peers, the company’s history, and growth prospects.
4. Is a PE ratio of 40 good?
It depends entirely on context. A P/E of 40 is high for most value-oriented or slower-growth sectors (utilities, banks, consumer staples) and would typically be viewed as expensive. For fast-growing technology, software, or biotech companies with strong competitive advantages and high expected earnings growth, a P/E of 40 can be acceptable or even attractive if the PEG ratio is near or below 1. Evaluate growth, margins, and peer comparisons before deciding.
5. Is it better to buy undervalued or overvalued stocks?
In general, buying undervalued stocks (those trading below intrinsic value) provides a margin of safety and is the foundation of value investing. Overvalued stocks can continue rising in the short term due to momentum or optimism, but they carry higher risk of sharp corrections if growth disappoints. High-quality companies with durable competitive advantages can sometimes justify premium valuations, yet disciplined investors usually prefer a margin of safety.
6. How to check if the stock is undervalued?
Start with a P/E below the sector average and the company’s own historical range. Confirm with a PEG ratio under 1, solid or improving earnings trends, healthy free cash flow, reasonable debt levels, and qualitative strengths (strong moat, capable management). Cross-check with other valuation methods such as discounted cash flow (DCF) estimates or price-to-book for asset-heavy businesses. A low multiple alone is not enough—rule out value traps caused by deteriorating fundamentals.
7. What is a good PE ratio for a stock to buy?
A “good” P/E is typically one that is reasonable relative to the company’s growth, quality, and peers—often in the mid-teens to mid-20s for many established businesses, though this varies widely by sector. Lower is generally better when quality and growth are comparable. Focus less on finding a magic number and more on whether the current price offers attractive expected returns based on future cash flows.
8. What are the 10 most overvalued stocks?
Lists of the most overvalued stocks change frequently and depend on the metric used (extreme trailing P/E, DCF models, PEG, etc.). Extremely high P/E ratios are often driven by temporarily depressed earnings and can reverse quickly.
As of mid-to-late October 2026, screens based on very high trailing P/E ratios highlight names such as Forgent Power Solutions (FPS), Freedom Holding Corp. (FRHC), Adecoagro (AGRO), BP, CoStar Group (CSGP), Jazz Pharmaceuticals (JAZZ), DraftKings (DKNG), Lattice Semiconductor (LSCC), Clearway Energy (CWEN), and Casella Waste Systems (CWST).
Larger, more widely followed stocks frequently flagged by DCF or relative-valuation models include Tesla (TSLA), Walmart (WMT), and Advanced Micro Devices (AMD).
9. What does Warren Buffett say about PE ratio?
Warren Buffett does not use a strict P/E cutoff. He has stated there is “no P/E ratio that we have in mind as being a cutoff point at all.” His focus is on estimating the future cash the business will generate over many years and buying at a discount to that intrinsic value. He has noted that absolute P/E ratios can rise with lower interest rates or higher returns on equity, and relative P/Es rise when investors become more optimistic about a company’s or industry’s prospects. In recent comments he has described many current valuations as high or “silly,” while still emphasizing business quality and long-term cash-flow power over any single multiple.
10. Does a low P/E always mean a stock is undervalued?
No. A low P/E can signal a genuine bargain, but it can also indicate a value trap—situations where the market correctly anticipates declining earnings, structural problems, high debt, poor management, or industry disruption. Always investigate why the multiple is low, examine forward earnings estimates, free-cash-flow trends, and competitive position before concluding the stock is undervalued.
Find Stock Opportunities Worth Researching
Stop spending hours searching for stocks without knowing which ones deserve your attention. Join the AllenVest Community for premium stock watchlists and market insights that help you identify companies to research, compare their valuations, and narrow down potential investment opportunities.
Learn to Identify Trading Opportunities with a Clear Strategy
Knowing a stock’s P/E ratio is not enough if you struggle to decide when to enter or exit a trade. ChartsEmpire helps you develop practical skills in chart analysis, trade entry and exit planning, and risk management, so you can evaluate opportunities using a structured process instead of relying on tips or guesswork.
Meet The Author
