Using the Price-to-Earnings Ratio as a Quick Way to Value a Stock

Image shows a woman at a computer and gesturing to the price to earnings ratio equation. Text reads: "What to know about price-to-earnings ratio: useful metric for evaluating relative attractiveness of a company's stock price compared to the firm's current earnings; P/E ratio is the price an investor is paying for $1 of a company's earnings or profit. Along with due diligence, examining P/E ratio can help you avoid getting swept away in bubbles, manias, and panics."

Image by Maddy Price © The Balance 2019

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.

Made popular by the late Benjamin Graham, who was dubbed the "Father of value investing" as well as Warren Buffett's mentor, 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, often offering 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 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.

Explaining the P/E Ratio

Before you can take advantage of the P/E ratio in your own investing activities, you must understand what it is. Simply put, the P/E ratio is the price an investor is paying for $1 of a company's earnings or profit.

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). 

For the sake of conservatism, use diluted earnings per share when calculating the P/E ratio so you account for the potential or expected dilution that can or will occur due to things like stock options or convertible preferred stock.

This is especially useful because, if you invert the P/E ratio by taking it divided by 1, you can calculate a stock's earnings yield. This can allow you to more 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, looking out for phenomena such as value traps, viewing both the individual stocks you hold in your portfolio, and your portfolio as a whole, through this lens can help you avoid getting swept away in bubbles, manias, and panics. It forces you to look through the stock market and focus on the underlying economic reality.

P/E Ratios by Industry

Different industries have different P/E ratio ranges that are considered normal for their industry group. For example, health care companies may sell at an average P/E ratio of 34, while energy sector companies may only trade at an average P/E ratio of 12.  There are exceptions, but these variances between sectors and industries are perfectly acceptable.

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. From time to time, the situation is turned on its head. 

In the aftermath of the Great Recession of 2008-2009, technology stocks traded at lower price-to-earnings ratios than many other types of businesses because investors were frightened. They wanted to own companies that manufactured products and that people would continue purchasing no matter how strained their finances; companies like Procter & Gamble, which makes everything from laundry soap to shampoo; Colgate-Palmolive, which makes toothpaste and dish soap; Coca-Cola; PepsiCo; and The Hershey Company.

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.

Such situations tend only arise every few decades but when they do, tread carefully and make sure you know what you are doing. 

Comparing Companies Using P/E

In addition to helping you determine which industries and sectors are overpriced or underpriced, you can use the P/E ratio to compare the prices of companies in the same area of the economy. For example, if company 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.

Company ABC may have reported earnings of $10 per share, while company XYZ has reported earnings of $20 per share. Each is selling on the stock market for $50. What does this mean? Company ABC has a price-to-earnings ratio of 5, while Company XYZ has a P/E ratio of 2.5. This means company XYZ is much cheaper on a relative basis.

For every share purchased, the investor is getting $20 of earnings as opposed to $10 in earnings from ABC. All else being equal, an intelligent investor should opt to purchase shares of XYZ. For the exact same price, $50, he is getting twice the earning power.

Limitations of the P/E Ratio

Just because a stock is cheap doesn't mean you should buy it. Many investors prefer the PEG Ratio, instead, because it factors in the growth rate. Even better is the dividend-adjusted PEG ratio because it takes the basic price-to-earnings ratio and adjusts it for both the growth rate and the dividend yield of the stock.

If you are tempted to buy a stock because the P/E ratio appears attractive, do your research and discover the reasons. Is management honest? Is the business losing key customers? Is it simply a case of neglect, as happens from time to time even with fantastic businesses? Is the weakness in 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?

Once you get more experienced, you will actually use a modified form of the P/E ratio that changes the "e" portion (earnings) for a measure of free cash flow. You can try something called owner earnings. Basically, use it, adjusted for temporary accounting issues, and try to figure out what you're paying for the core economic engine relative to opportunity costs. Then, construct a portfolio from the ground-up that not only contains individual components that were attractive but also together reduces risk.

Article Sources

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