When you invest in stocks, it's natural to want to know if you're paying a fair price. One of the most straightforward ways to measure this is through the Price-to-Earnings (P/E) ratio. But what if you’re investing in Exchange-Traded Funds (ETFs), which bundles multiple companies together? Calculating the P/E ratio becomes a little different. In this article, we’ll clearly break down how to calculate the P/E ratio for ETFs, why it’s important, and common mistakes to avoid.
The P/E ratio is essentially a measure of how expensive a stock or ETF in this case is relative to the profits (earnings) it generates. If a company has a stock price of $100 per share and earns $10 per share annually, its P/E ratio would be 10 ($100 ÷ $10 = 10). This means investors are paying $10 for every $1 of annual earnings. Generally speaking, a lower P/E ratio indicates the stock might be undervalued (or cheap), while a higher ratio indicates investors expect higher growth in the future.
When dealing with ETFs, the calculation isn't as straightforward as just P/E. Why? Because an ETF doesn’t include just a single company. It’s a basket of many different companies. Each company within an ETF typically has a different weighting (importance within the ETF), earnings, and profitability.
S&P 500 Top 13 Companies in terms of Weightage – Image taken from slickcharts.com
Therefore, rather than a simple division, ETF P/E calculations involve using weighted average of the P/E ratios of the profitable companies included. For example, an ETF tracking 500 different companies will not give equal weight to each. Large companies often have a higher weighting, influencing the ETF’s overall P/E more significantly.
Another complexity arises when some companies in the ETF have negative earnings (i.e., they're unprofitable). Negative earnings don’t make sense mathematically in a traditional P/E calculation because they distort the ratio. As a result, ETF providers typically exclude these unprofitable companies from their P/E calculations. While this makes the calculation practical, it can also give an artificially lower P/E ratio, particularly if the ETF contains many early-stage or growth companies that might be currently unprofitable.
Let’s consider an ETF that tracks three companies: Company A, Company B, and Company C. Suppose Company A makes up 40% of the ETF and has a P/E of 20. Company B has 30% weighting and a P/E of 25. Company C, representing the remaining 30%, is unprofitable (negative earnings), so we exclude it from the calculation entirely.
|
Company |
Weightage |
P/E Ratio |
|
Company A |
40% |
20 |
|
Company B |
30% |
25 |
|
Company C |
30% |
Negative Thus Excluded |
Company C is unprofitable, so it won't be counted.
Readjust the weightage based on existing profitable companiesCompany A : 40/70 x 100 = 57.14%
Company B : 30/70 x 100 = 42.857%
Multiply each company's P/E by its weight:Company A: 57.14% × 20 = 11.4
Company B: 42.85% × 25 = 10.5
Sum these weighted results:Therefore, the ETF’s overall P/E ratio is 21.9
Think of it like evaluating houses. Calculating the P/E ratio for a single stock is like assessing the price of a single house based on its features and neighborhood. On the other hand, an ETF’s P/E ratio is similar to evaluating an entire neighborhood with many different houses, each with different values and features. It's about finding the overall average.
Negative earnings can complicate ETF P/E ratio calculations but here’s an important nuance. To be included in the S&P 500, a company must initially demonstrate profitability, with positive earnings reported in the most recent quarter and cumulatively across the last four quarters.
However, once a company is part of the index, it isn't immediately removed if earnings turn negative. That means ETFs tracking the S&P 500 like SPY can rarely include companies that have become unprofitable, which may subtly impact the overall P/E calculation. This effect is even more pronounced in ETFs that track broader or more specialized indices, where unprofitable companies are more common and can significantly distort the P/E ratio.
The key takeaway? Always understand how an ETF is constructed before drawing conclusions from valuation metrics.
When evaluating the P/E ratio, investors typically come across two types: trailing P/E and forward P/E. A trailing P/E is based on actual earnings from the past 12 months. It reflects a company or ETF’s historical performance, offering a grounded and fact-based snapshot. This makes it especially helpful when assessing financial stability, comparing against long-term historical averages, or evaluating mature, dividend-paying businesses where past results carry meaningful weight. However, since it’s backward-looking, it may not be as useful in fast-changing or growth-driven markets where historical earnings don’t always reflect future potential.
In contrast, a forward P/E uses analysts’ forecasts for the next 12 months, offering insight into what the market expects going forward. This could be particularly useful when analyzing sectors like technology or biotech, where future growth potential is a key factor. That said, forward P/E relies heavily on assumptions and earnings projections, which can be off the mark in volatile or uncertain market conditions.
Ultimately, knowing when to use each depends on the insight you're looking for: trailing P/E offers a reliable view of where a company has been, while forward P/E gives a sense of where it might be headed.
Let’s say you're comparing two ETFs: XLK, which focuses specifically on tech companies, and QQQ, which includes both tech and other sectors like consumer discretionary and healthcare.
Now imagine XLK has a forward P/E ratio of 25, while QQQ is sitting at 20. At first glance, it might seem like XLK is overvalued. But here’s the catch: tech stocks naturally trade at higher P/E ratios because of their growth potential. XLK’s higher valuation simply reflects its heavier exposure to high-growth names.
So don’t compare P/E ratios across sectors blindly. A high P/E in one sector (like tech) might be standard, while a lower P/E in another (like utilities or industrials) might still be expensive relative to its peers. If you were to compare, it’s only logical to compare ETFs within similar categories for meaningful insights.
Evaluating an ETF’s P/E ratio requires more than simply reading a number—it involves understanding how the ratio is calculated, which companies are included, how sector weightings influence the result, and other underlying factors that can impact its interpretation.
At Piranha Profits, we believe that smarter investing comes from deeper understanding. Whether you’re a long-term investor or a hands-on trader, being able to interpret P/E ratios properly can help you avoid common mistakes and spot opportunities others might miss.