Price/Earnings (P/E) Ratios

(4 of 9)

Price/Earnings (P/E) Ratios

P/E is the most popular valuation ratio used by investors. It is equal to a stock’s market price divided by the earnings per share for the most recent four quarters. The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales. Moreover, earnings per share results and estimates about the future are easily available from just about any financial data source imaginable.

What P/E really means

The P/E ratio measures how much investors are willing to pay for a company’s earnings. Generally speaking, the higher the P/E ratio, the more investors are willing to pay for a dollar’s worth of a company’s earnings. Stocks with high P/Es (typically those with a P/E exceeding 30) usually have greater future growth prospects, while stocks with low P/Es (typically those with a P/E below 15) tend to have lesser future growth prospects. However, a P/E ratio by itself does not say much about a stock’s valuation.

How to compare P/E ratios: benchmarks

The most useful way to use a P/E ratio is to compare it with a certain benchmark. Good benchmarks are the P/E of another company in the same industry, the P/E of the entire market, or the same company’s P/E at a different point in time. Each of these approaches has some value, as long as you know the limitations.

For example, a company that is trading at a lower P/E than its industry peers could be a good value, but even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the P/E ratio. All else equal, a firm that has better growth prospects, lower risk, and lower capital reinvestment needs should be rewarded with a higher P/E ratio.

How to compare P/E ratios: the whole market

You can also compare a stock’s P/E with the average P/E of the entire market. However, the same limitations of industry comparisons apply to this process as well. The stock you are investigating might be growing faster (or slower) than the average stock, or it might be riskier (or less risky). In general, comparing a company’s P/E with those of industry peers or with the market has some value, but you should not rely on these approaches to make final buy or sell decisions.

How to compare P/E ratios: historical P/E ratios

Comparing a stock’s current P/E with its historical P/E ratios can also be of value. This is especially true for stable firms that have not undergone major business shifts. If you find a solid company that is growing at roughly the same rate with roughly the same business prospects as in the past, but is trading at a lower P/E than its long-term average, you should start getting interested. It’s entirely possible that the company’s risk level or business outlook has changed, in which case a lower P/E is warranted, but it’s also possible that the market is simply pricing the shares at an irrationally low level.

The drawbacks

The P/E ratio also has some important drawbacks. A P/E ratio of 15 does not mean a whole lot by itself; it is neither good nor bad in a vacuum. As we discussed previously, the P/E ratio only becomes meaningful with context.

However, keep in mind that using P/E ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. After all, there will be periods when entire industries will become overvalued. In 2000, an Internet stock with a P/E of 75 might have looked cheap when the rest of its peers had an average P/E of 200. In hindsight, neither the price of the stock nor the benchmark made sense. Just remember that being less expensive than a benchmark does not mean something is cheap, because the benchmark itself may be vastly overpriced.

P/E distortions: inflated earnings and business cycles

When you’re looking at a P/E ratio, also make sure that the "E" part of the equation makes sense and is representative of a company’s ongoing profits. A few things can distort the P/E ratio. First, firms that have recently sold off a business can have an artificially inflated "E" and a lower P/E as a result. A company may book a big one-time gain from the sale of a division, boosting reported earnings, but based on operating earnings, the stock may not be cheap at all.

Second, reported earnings can sometimes be inflated (or depressed) by one-time accounting gains (or charges). As a result, the P/E ratio can be misleadingly high or low. For example, a firm’s earnings can be depressed due to a one-time charge for litigation or other extraordinary events. This may in turn give the stock what appears to be a sky-high trailing P/E.

Third, cyclical firms that go through boom and bust cycles—semiconductor companies and auto manufacturers are good examples—require a bit more investigation. Although you would typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon. Likewise, a cyclical stock is going to look the most expensive when its "E" has bottomed and is about to start growing again.

The two P/Es

Lastly, there are two kinds of P/Es—a trailing P/E, which uses the past four quarters’ worth of earnings to calculate the ratio, and forward P/E, which uses analysts’ estimates of the next four quarters’ earnings to calculate the ratio. Because most companies are increasing earnings from year to year, the forward P/E is almost always lower than the trailing P/E, sometimes markedly for firms that are increasing earnings at a very rapid clip. Unfortunately, estimates of future earnings by Wall Street analysts—the consensus numbers you often read about—are consistently too optimistic. As a result, buying a stock because its forward P/E is low means counting on that future "E" to materialize in its entirety—and that usually doesn’t happen.