Understanding Stocks: The P/E Ratio

The price earnings ratio is one of the most popular ratios in analyzing stocks. It can be a good starting point to differentiate between a promising stock and a not so promising stock. However, by itself it is meaningless. For a P/E ratio to have meaning, it needs to be compared relative to other P/Es.

In a way, P/E is similar to a popularity contest. It indicates how much an investor is willing to pay for each dollar of earnings. The higher the P/E, the more an investor is willing to pay for each dollar of earnings. For example, if the P/E ratio is 8, it means an investor is willing to pay 8 dollars for every one dollar of earning. If a P/E ratio is listed as n/a, it means the company has no earnings or negative earnings.

 

 

P/E can be computed in two different ways. One way is to divide the price per share by the company’s earning. The other way is to divide market capitalization by net income. Information about P/E ratios are normally listed at any financial website that gives stock quotes. For example, Yahoo Finance not only gives the stock quote but a whole array of other financial information.

Historically, the S&P’s 500 Index’s P/E ratio has ranged between 15 and 25. Generally, a market P/E over 18 is considered expensive or overvalued while a market P/E under 10 is considered inexpensive or undervalued. However, keep in mind, there are no right or wrong P/E ratios. One way to determine if the P/E is at an appropriate level is to compare it to the company‘s growth rate. As a rule of thumb, most stocks trade with P/Es that 50% higher than their forecasted earning’s growth.

 

 

 

Although the P/E tells you how much an investor is willing to pay for each dollar of earning, P/Es are more useful when there is a comparison base. Therefore, before you begin comparing, it is important to know the stock’s normal P/E. A company’s P/E can be compared against:

• The S&P’s 500 Index P/E
• The company’s sector P/E
• The company’s industry P/E
• The company’s historical P/E
• The company’s forward P/E

After you have compared the P/E against other P/Es, what were the results? Were the results significantly different? If so, search for the reason why it is different.

Before purchasing a stock, it is important to know the stock market’s direction. Examine the S&P’s 500 Index’s P/E over time. Is it’s P/E ratio going up or down? This gives you a good idea of the market trend. When evaluating the markets P/E as a whole, if the P/E is above 25, there has usually been a market correction.

After analyzing the S&P, you can compare the trailing P/E to the forward P/E. Unlike the trailing P/E which is most commonly used when we speak of P/E, the forward P/E is calculated differently. With the trailing P/E, earnings are calculated using the four most recent quarters. Conversely, the forward P/E is calculated using the expected earnings for the four upcoming quarters. If the forward P/E is higher than the trailing P/E, it means the future earnings are expected to be more than the current earning.

When comparing a company’s P/E to it’s sector’s P/E, it is important to remember that different sectors have different expectations. A P/E that is considered high for one sector may be considered low for another company. For example, the technology sector generally has a higer P/E than the utility sector. This is because the technology sector usually has high growth rates and earnings prospects. If a sector’s current P/E is higher than it’s historical P/E, it could be over-priced and ready for a fall. Furthermore, when analyzing P/E, an investor should compare different sector’s P/Es against each other.

Companies in the same sector or industry usually move together. Thus, if a stock is selling at a premium or discount in relationship to the other stocks in the sector or industry, there is usually a reason why. Therefore, it is important to research the stock further. A stock could be selling at a premiun because investors have high expectations for the company’s growth and earning. On the other hand, the earnings may not be as good, but it is not reflected in the shareholder’s sentiments yet. Hence, it is over-valued. The opposite is true for a stock with a lower P/E. The business may have better earnings, but it is not reflected in the shareholder’s sentiments. Another reason is the business may have something wrong which is affecting it’s earning.

There are no right or wrong P/E ratios. One way to determine if the P/E is at an appropriate level is to compare it to the company‘s growth rate. As a rule of thumb the P/E should equal the company’s growth rate. If the P/E is significantly different, it is important to scour the company‘s financial data and any relevant news to see what is influencing the ratio. Some factors you may wish to look at are:

• Were there any changes in earnings?
• Were there any changes in debt
• Were there any changes in management?
• Were there any changes in pantents, technology, or products?
• Were there any lawsuits?
• Were there any labor?
• Were there any takeovers or mergers
• Were there any stock splits?
• Were there any buybacks?
• Were there any changes in expenses?
• Were there any changes in sales?
• Were there any changes in dividends?

When evaluating the P/E, it is also important to remember that earnings can be skewed by accounting methods or one time accounting events. Furthermore, market bubbles or changes in the economy can also affect the P/E ratios. During times of low interest rates, P/E ratios are usually higher because a company’s cost of capital is less and investors clamor to the stock market when bond yields are less.

The P/E can also help you determine the risk premium of a stock. The risk premium is the difference between a company’s earning’s yield and the interest on long-term, risk-free bonds. To calculate the earning’s yield of a company, invert the P/E ratio. If the P/E ratio is 65, the earning’s yield is 1.5%. By contrast, the current 10-year Treasury bond yield is 2.74%. Thus, why put your money in a company that only yields 1.5% when you can invest your money in Treasury bond with a risk-free return of 2.74%?

P/E ratios can be a useful ratio when it is used for comparison. It can serve as a red flag by informing investors when something is out of the ordinary. Therefore, do not make any investment decisions based on P/E alone. The best advice in choosing any investment is to proceed with caution and due diligence.