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

How to Interpret the Price to Earnings Ratio

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In the world of investments, P/E stands for Price/Earnings. The price/earnings ratio is a measure of the current share price of a company as compared to per-share earnings (market value per share divided by earnings per share).

The higher the ratio, the greater the amount that an investor is willing to pay for $1 of current earnings. So a stock with a high P/E is generally expected to increase in value. A stock with a low P/E may already be doing well, or it may simply be undervalued.

It is possible to invest based on the P/E of an individual stock, but most people look at an overall P/E ratio for the market. Many people say the stock market is overvalued when the P/E ratio of the market is above average. You may wonder what qualifies as average for the market, and here are a few historical high and low points in the market that will give you some insight into normal, abnormal, and average P/E ratios.

P/E Ratio Highs and Lows of 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 close to 40. To date, this is an all-time high for that ratio.

At the bottom of the worst bear markets, the stock market (S&P 500 Index) has traded at a P/E ratio of close to 7.

The average P/E ratio of the market is about 14.

Common Sense Investing Using the P/E Ratio

A P/E ratio of 40 is really high, a P/E ratio of 7 is really low, and a ratio of 14 represents the average over modern history. Armed with this information, you can look up the current P/E ratio of the stock market and figure out where things are relative to historical times.

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, 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 continue to rise 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 thought the market was overvalued based on P/E ratios, and thus they missed years of great returns from 1994 to 1999.

Sector P/E Ratios

Investors don't just look at the P/E of just the market. They sometimes look at individual sectors and even 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.

Lessons to Learn from Past P/E Bubbles

In the early 70s, there was a group of stocks called the Nifty Fifty. These were fifty of the largest companies listed on the stock exchange, and institutions bought giant-sized positions of their stock. As stock prices soared, the P/E ratios of these companies grew to highs in the range of 65-92. The market crash of 73/74 came along, and by the early ’80s, these same companies had P/E ratios of 9 to18.

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 ’90s with tech stocks. P/E ratios of the tech favorites routinely exceeded 100. 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 could be "on sale."