P/E Ratio and How to Use It to Make Smart Investments

How to Interpret This Important Metric

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In the world of investments, a company’s price-to-earnings ratio, or P/E ratio, is a measure of its stock price relative to its earnings. If you’re trying to determine whether a stock is a good investment, the P/E ratio can help you gauge the future direction of the stock and whether the price is, relatively speaking, high or low compared to the past or other companies in the same sector.

The P/E ratio is a simple calculation: the current stock price divided by the per-share earnings (the earnings for the past 12 months divided by the common shares outstanding.) For example, if a company is selling at $20 per share and the per-share earnings are $2, then the P/E ratio is 10. You may also hear people say “the stock is selling at 10 times earnings.”

A stock with a rising P/E generally means investors are bullish about the stock. A stock with a declining P/E may mean the market has less confidence in the company’s future earnings growth, or it may simply be undervalued. 

You can invest based on the P/E of an individual stock, but many people look at the overall P/E for the market. One interpretation is that the stock market is overvalued when the P/E ratio is above average. So what qualifies as average for the market? Here are a few historical high and low points to provide some perspective.

An earnings report tells you how the company is performing. A P/E ratio tells you how investors perceive how the company is performing. In other words, how much they are willing to pay for a dollar’s worth of earnings.

High and Low P/Es for the S&P 500

At the peak of the internet/technology bubble of the 1990s, the stock market—as measured by the S&P 500 Index—was trading at a P/E ratio of over 40. (This is not the absolute P/E, but the Shiller P/E, which is based on average inflation-adjusted earnings from the previous 10 years.) At the bottom of the worst bear markets, the Shiller P/E ratio for the S&P 500 was under 5. 

In other words, the Shiller P/E ratio is really high if it’s over 40 and really low if it’s under 10. The median for modern history is in the mid-teens.

Look up the current Shiller P/E ratio here to figure out where things are relative to historical times.

Common Sense Investing Using P/E

The important thing to remember is that there is not a set rule you can apply. You must factor in what is going on in the world. For example, if the economy is in trouble or there is a global health crisis, corporate earnings can be worse than expected. This lowers investor expectations, and stock prices will go down. Even if the market seems fairly valued at a P/E ratio of 14, bad times could cause the market returns to continue on a downward spiral with the P/E ratio going much lower.

On the other hand, during booming economies, corporate earnings can continue to rise, and stock prices can increase for many years in a row. A P/E ratio of 16, or even 20, does not automatically mean the market is overpriced. In the early ’90s, many who thought the market was overvalued based on P/E ratios missed the great returns of 1994 to 1999.

Sector P/E Ratios

Beyond looking at the P/E of the overall market, investors look at the P/E of industry sectors and individual stocks. Each sector has its own "normal" P/E. One would expect the P/E of technology stocks to be higher than industrial stocks, for example, because investors are willing to pay for the larger upside that many technology stocks have to offer. 

Comparing a sector’s current P/E to its historical average can also be helpful. If the current P/E is lower than it’s been in the past, it may indicate that the sector is undervalued. Conversely, if the P/E is higher than average, it may mean the sector is overvalued.

Lessons to Learn from Past P/E Bubbles

In the 1960s and early 1970s, a group of stocks called the Nifty Fifty—including many household names like McDonald’s, Polaroid and Johnson & Johnson—became symbols of the prosperous times. As stock prices soared, the P/E ratios grew to highs over 60, 70 and 90, in some cases. Then came the market crash of 1973/1974, and many of these stock prices plummeted. 

No sizable company can continuously increase their earnings fast enough to justify that level of investment. The lesson wasn’t learned, however, and the situation repeated itself in the late 1990s with tech stocks. P/E ratios of the tech favorites soared. Some companies had no profits, yet, commanded higher ratios compared to more conservatively run companies.

The lesson to be learned is that abnormally high P/E ratios, combined with exuberant headlines, can be a signal that the market is overheated and equity exposure should be reduced. Abnormally low P/E ratios, combined with pessimistic headlines, can be a signal that equity prices are "on sale."

Article Sources

  1. U.S. Securities and Exchange Commission. "Price-earnings (P/E) Ratio." Accessed March 9, 2020.

  2. Charles Schwab Corp. "Stock Analysis Using the P/E Ratio." Accessed March 9, 2020.

  3. Morningstar. "6 Things to Note About the P/E Ratio." Accessed March 9, 2020.

  4. Siblis Research. "CAPE and P/E Ratios by Sector 1979-2019." Accessed March 9, 2020.

  5. Stewart Investors. "Lessons from the Past - The Nifty Fifty." Accessed March 9, 2020.