Using the Price-to-Earnings Ratio as a Quick Way to Value a Stock
In the world of investments, a company’s price-to-earnings ratio, or P/E ratio, is the measure of a 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 compared to other companies in the same sector.
This ratio was popularized by the late Benjamin Graham, who, aside from being Warren Buffett's mentor, is credited with inventing "value investing." Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis. He often offered some modifications and additional clarification so it had added utility when viewed in light of a company's overall growth rate and underlying earning power.
An earnings report tells you how a company is performing. The P/E ratio tells you investors' perception of the company's performance. In other words, it demonstrates how much they are willing to pay for $1 worth of earnings from a given company.
Explaining the P/E Ratio
Before you can take advantage of the P/E ratio in your own investing activities, you should understand what it is. It's an easy ratio to calculate once you know a company's stock price and earnings per share (EPS). The equation looks like this:
- P/E ratio = price per share ÷ earnings per share
In other words, if a company is reporting basic or diluted earnings per share of $2 and the stock is selling for $20 per share, the P/E ratio is 10 ($20 per share divided by $2 earnings per share = 10 P/E). This is especially useful because, if you invert the P/E ratio, you can calculate a stock's earnings yield. The yield equation looks like this:
- Earnings yield = earnings per share ÷ price per share
This can allow you to easily compare the return you are actually earning from the underlying company's business to other investments such as Treasury bills, bonds, and notes, certificates of deposit and money markets, real estate, and more.
As long as you do your due diligence and look out for trading phenomena such as value traps and exuberance, viewing your portfolio through this lens can help you avoid getting swept away in bubbles, manias, or panics. The P/E helps you identify whether a stock is becoming overvalued and no longer earns enough to justify a price.
You should never rely on P/E ratios alone when you choose investments. P/E ratios can help guide your decision-making, but only in the context of extensive research and multiple technical assessments.
P/E Ratios by Industry or Sector
Different industries have different P/E ratio ranges that are considered normal for their industry group. For example, Fidelity research in January 2021 pegged the average health care company's P/E ratio at nearly 70, while banking sector companies averaged a P/E ratio of just under 11.5.
There will always be exceptions, but it's normal to observe these kinds of variances between sectors and industries. They arise, in part, out of different expectations for different businesses. Software companies usually sell at larger P/E ratios because they have much higher growth rates and earn higher returns on equity, while a textile mill subject to dismal profit margins and low growth prospects might trade at a much smaller multiple. These norms aren't set in stone, and sentiments toward different sectors can shift.
In the aftermath of the Great Recession of 2008-2009, technology stocks traded at low price-to-earnings ratios because investors were frightened. As the economy improved, investors began returning, and in 2021, Fidelity estimates the industry-wide P/E average to be roughly 42.
Comparing Companies Using P/E
In addition to helping you determine which industries and sectors are over or underpriced, you can use the P/E ratio to compare the prices of companies in the same sectors of the economy. For example, if companies ABC and XYZ are both selling for $50 a share, one might be far more expensive than the other depending upon the underlying profits and growth rates of each stock.
If ABC reported earnings of $10 per share, and XYZ reported earnings of $20 per share, it means that company ABC has a price-to-earnings ratio of 5, while Company XYZ has a P/E ratio of 2.5. XYZ is a better purchase at that time because of the lower share price complemented by similar earnings. For every share purchased, the investor is getting $20 of earnings from XYZ as opposed to $10 in earnings from ABC.
Limitations of the P/E Ratio
The important thing to remember is that there is not one ratio or set rule you can apply for investing success. You must factor in what is going on in the world, the markets, and the economy.
For example, if the economy is in trouble or there is a global health crisis, corporate earnings can be worse than expected and stock prices can rapidly fluctuate. An investment may experience a decline and subsequently seem fairly valued at a P/E ratio of 14, but if an investor jumps into the position too soon without assessing the overall market conditions, the P/E could further decline. On the other hand, during booming economies, corporate earnings can continue to rise, and the P/E can sustainably increase for many years in a row.
A low stock price doesn't necessarily mean you should buy it—nor does a low P/E ratio. Without broader context, you can't be sure that a low P/E truly signals a good investment. For example, investors may prefer the price-to-earnings growth (PEG) ratio instead because it factors in the earnings growth rate. Other investors may pay more attention to the dividend-adjusted PEG ratio because it uses the basic price-to-earnings ratio and adjusts it for both the growth rate and the dividend yield of the stock.
The Bottom Line
If you are tempted to buy a stock because the P/E ratio appears attractive, do your research and figure out whether it's truly as good as it seems. Is management honest? Is the business losing key customers? Is the stock price or underlying financial performance a result of forces across the entire sector, industry, or economy, or is it caused by firm-specific bad news? Is the company going into a permanent state of decline?
The basic P/E ratio is an indicator that's great when used in context, but not all that useful by itself—at least not until you become very familiar with your investments and opportunities. As you grow more accustomed to the ratios, industries, and sectors you want to invest in, you'll be able to view a P/E from a period of time for a company and decide whether it is a good indicator or not.