Understanding the P/E Ratio
Don’t make this amateur investing mistake…
In this latest bull market and period of new IPOs, there are a lot of people on the Street clamoring about where a stock is selling or its “multiple.” And they all act as if this number is the end-all be-all.
The reference is to the P/E ratio. While it’s one of the oldest and most frequently used metrics, it can also get you into some trouble if taken out of context.
What is it Exactly?
The P/E ratio measures the relationship between a stock’s price and its earnings, or profits per share. Here’s the calculation:
P/E = price per share/earnings per share (EPS)
You take a company’s stock price and divide it by its last 12 months of earnings per share. This is a trailing P/E. Everyone wants more earnings for every dollar you invest. So in theory, a lower P/E is considered more attractive…
What Does it Tell You?
The P/E ratio gives us a clue to what the market is willing to pay for a company’s earnings. The higher the P/E, the more the market is willing to pay for the company’s earnings – and vice versa.
Some investors interpret a relatively high P/E as overpriced (The best gauge of whether a P/E is high or not is to compare it to very similar industry competitors.) On the flip side, the market may be very bullish about the company’s future and has bid up the stock price – leading to a higher P/E.
A company with a relatively low P/E may be overlooked or ignored by the market. This is the ideal prize for value shoppers. But this same position could mean that the market has driven the stock price down because the company just has bad fundamentals.
An Incomplete Picture…
But P/E paints an incomplete picture, and here’s why:
- The P/E ratio usually looks backwards. If one company is able to double its earnings in a few short years while another remains stagnant, the former could be a much better value despite a higher multiple. Yet you wouldn’t know it from the single-snapshot picture the P/E provides.
- The “forward P/E” published by some sources is a better tool, because it uses the next year’s pro forma earnings instead of last year’s earnings. But this picture is still limited since it’s just an educated guess at next year’s earnings.
- Remember that accountants can do some creative things with reported earnings. While one company may report a largely honest number, another may be manipulating earnings per share to meet market expectations.
The Lesson to Be Learned
First of all, P/Es need to be placed in a context that gives them meaning in which they’re compared to competitive companies or to an industry average.
And maybe most importantly, the P/E ratio should never be the only metric used when trying to determine whether a company is currently overvalued or undervalued. It doesn’t matter if it’s a trailing or a forward P/E. No ratio should be used in isolation for that matter.
The P/E becomes more useful if you can get a grasp on just how much in earnings a company will be able to achieve over the coming years. But in order to do this, you’ll need to study the underlying business and understand its margins, scalability and competitive position within the industry.
So long story short, the P/E is a helpful metric. But don’t make the common amateur mistake of letting it be an end-all, be-all valuation metric.