When venturing into the world of investing, understanding the myriad of metrics and terms can be daunting. One such critical measure is the Price-to-Earnings (P/E) ratio, a tool widely used to evaluate the value of a stock.
Coined by Mr. Benjamin Graham, known as the father of value investing, the P/E ratio is more than just a number; it’s a lens through which the financial health and potential of a company can be assessed.
This beginner’s guide delves into the intricacies of the P/E ratio, helping investors, both novice and seasoned, make informed decisions by interpreting this crucial financial indicator.
What Is a P/E Ratio?
A P/E ratio, the market’s expectations of a company’s worth, compares a stock’s price to its earnings per share(EPS.) It reflects how investors view a company through its stock price based on its past earnings or anticipated earnings in the future. When applying to an index like the S&P 500, the P/E ratio evaluates the status of a group of companies.
The P/E ratio is one famous method investors and analysts resort to gauge a stock’s value. Here are the four principal utilities of using P/E ratios:
- Compare a company with other companies of a similar nature using P/Es to find out the company’s overall characteristics like earnings power and market value.
- Ascertain its value, whether overvalued, correctly valued, or undervalued.
- Decide if they should buy, hold, or sell a company based on its value.
- Analysts may consider whether stocks of an industry of companies are expensive or cheap if employing the ratio to that of a sector.
A Company with a lower P/E than other companies in the same industry is generally viewed as undervalued, overvalued with a higher P/E, and correctly valued with a P/E matching with peers.
Pros and Cons
Pros
- Easy-to-use metric: A P/E ratio is a simple-to-use metric for all levels of investors according to CMC markets. Investors can use it to identify potential companies and make informed investment decisions.
- To identify an investible prospect: A stock with a low P/E ratio may be a potential investment opportunity for investors due to its undervalued status. Investors expect to profit from a price surge to the long-term average level.
- Widely accepted: As the name implies, a P/E ratio comprises 2 simple factors: per share price divided by earnings per share(EPS). Investors, financial advisors, and analysts always include it as one of the significant metrics to identify investment opportunities.
Cons
“The P/E ratio is a useful tool, but it is not a Holy Grail of investing,” said Mr. John Bogle, the founder of the Vanguard Group. He suggested investors should use it with other analytical tools to make an accurate prediction.
- Can be deceptive: A P/E ratio is misleading if not used with other metrics or factors, such as a company’s financial strength, growth prospects, and industry trends.
- Misleading accounting practices: A company may use aggressive accounting practices to produce a low P/E ratio, contrasting with a company using conservative practices to create a relatively high P/E when other performance indicators are similar.
- Industry variances: P/E ratios for respective industries vary. Investors may render P/E ratios worthless when comparing P/Es across industries and sectors as conditions differ.
- Flaws: The P/E ratio reflects a company’s financial status based on past financial performance, which may not guarantee future operations. Even for investors using the predicted earnings for analysis, an estimated P/E may not yield the expected result.
How to Calculate the P/E Ratio
Here is an example of calculating a P/E ratio:
X company reports a stable quarter-over-quarter income of S$2.5 per share on its financial statements. The market price for the company is S$50 per share. In this example, the P/E ratio for X is 50/2.5 = 20: a price for an investor willing to buy a company share for 20 times its earnings, matching the average industry P/E and correctly valued.
Suddenly, X’s share price soars to S$62.50 per share, changing the P/E to 62.50/2.5 = 25. The newly set P/E makes X company’s share more expensive than its peers or industry’s and overvalued.
On the contrary, a dip in price to S$40, leading to a lower P/E ratio of 40/2.5 = 16, lower than the industry or its peers, may attract more investors due to being undervalued, while others are constant.
What is a Good P/E Ratio?
“A low P/E ratio can be a useful tool for identifying, but it is important to look at the company’s overall financial health and long-term prospects,” said Mr. Philip Fisher, the author of “Common Stocks and Uncommon Profits.”
No definition for a good P/E ratio is available to judge a stock price. But you can look for a stock with a sound price by comparing a P/E with other stocks and examining the company’s and industry’s growth prospects.
That said, a company with proper financial health, a bright outlook in a fast-growing industry, and a lower P/E than its peers, having the same performance as other companies in the same sector, is deemed undervalued and a potential investment opportunity to investors.
P/E Ratio Example
“Look for stocks with high earnings growth and low P/E ratios,” said Mr. Peter Lynch, the former manager of the Fidelity Magellan Fund.
Investors and analysts, combined with other tools like a company’s operating and financial soundness, can use a P/E ratio to identify investment opportunities.
Below are some notable signals caused by changes in a company’s P/E ratios when an investor examines a company’s prospects:
Low P/E ratio
A company’s stock may be undervalued.
Compared with other companies within a sector, a low P/E stock may indicate that the market ignores its true worth based on earnings.
In the case above, the company’s earnings power may stay at the same bar as its peers in the same industry. However, the market does not price the stock higher with its increasing earnings. Expecting the stock price to line up with the market, value investors may view this as an investment opportunity to buy the stock.
A company’s earnings are falling.
“However, a low P/E ratio can also be a sign that the company is facing challenges or has limited growth prospects,” said Mr. Peter Lynch, the legendary investor.
A low P/E ratio may signal investors’ negative attitude toward the stock due to concerns about its earnings prospects. The stock price is selling at a lower par with its peers.
Separating undervalued stocks from problematic ones requires further investigations before making investment decisions. A thorough review of a company’s earnings and financial health helps you understand a company when making investment decisions.
High P/E ratio
“High P/Es are not always a bad thing, they can be justified by strong growth prospects or a strong competitive position. However, investors should be careful not to overpay for stocks with high P/E ratios,” said Mr. Michael Mauboussin, head of Consilient Research at Counterpoint Global at Morgan Standley Investment Management.
Investors anticipate higher earnings in the future.
A rising P/E may imply investors are optimistic about a company’s future earnings and willing to pay higher premiums for a stock owing to the earnings potential.
A high P/E may signal that a company may increase its earnings significantly, defining itself as a growth stock and leading to a possible rise in its worth.
A stock may be overvalued.
“High P/E ratios can be dangerous because they encourage investors to buy stocks based on hype rather than fundamentals. This can lead to bubbles and crashes,” said Mr. David Swensen, the former chief investment officer of Yale University Endowment.
A high P/E may be problematic for a company compared to its peers within the same sector. The company may have earnings growth prospects, leading to an overvalued status.
An overvalued stock occurs when its price does not change, but the earnings fall below the past or the industry average, leading to the reduced nominator and a false higher valuation.
Investors should avoid misreading P/E ratios and distinguish whether a stock is growth-oriented or growth-overestimated. Further analysis with other tools is necessary to reach an objective decision.
Three Variants of the P/E Ratio
A P/E ratio is a popular tool for analyzing stocks because it requires only 2 components in the formula. Recently, more investors and analysts have changed the earnings definition to extract more accurate details to predict stock prices. Here are the 3 most popular variants of the P/E ratio.
1. Trailing 12-month (TTM) earnings
The method uses the earnings of the past 12 months to calculate a P/E ratio. Its advantage is using confirmed and actual data to evaluate a company’s past performance. However, prior data do not guarantee future success. Besides, a company’s record of fluctuating earnings makes use of the ratio less meticulous.
2. Forward earnings
Instead of using past figures, investors use the forecasted 12-month earnings as a base to calculate forward P/E ratios. To make the P/E more accurate, analysts research and dig for more data to reach a more reliable consensus on a forward P/E ratio.
3. The Shiller P/E Ratio
The well-known ratio called cyclically adjusted priced earnings ratio or CAP/E ratio, averages the past 10 years’ inflation-adjusted earnings instead of past or future earnings, as the previous 2 P/E ratios may inflate earnings records. Most investors use the Shiller P/E of the S&P 500 index.
How to Use the P/E Ratio
One rule of thumb in an initial review of a stock is to look at its P/E before any in-depth examinations. A higher P/E may signal a promising earnings prospect and present an investment opportunity like Amazon(AMZN: a high P/E of 76 as of Dec 12, 2023.)
Another high P/E company facing earnings prospects is Wynn Resorts Limited(WYNN: a high P/E of 307 as of Dec 12, 2023). Wynn faces fluctuating earnings and growth prospects, leading to unstable P/Es.
Valero Energy Corp(VLO: a low P/E of 4.12 as of Dec 12, 2023) confronts the earnings outlook issue as oil prices and chemical demands are falling. The low P/E may signal a falling revenue and earnings ahead.
United Airlines Holdings Inc.(UAL: a low P/E of 4.76 as of Dec 12, 2023) is recovering from low demands from mild recession and pandemic, where Revenue and earnings are gaining from previous quarters. The airline may present an investment opportunity and growth potential in the future.
P/E Ratios and Future Stock Returns
The relationship between P/E ratios and future stock returns is still a heated debate among investors and scholars.
Mr. Eugene Fama and Mr. Robert Schiller argue for a negative relationship between the P/E ratio and future stock returns in their book “ The Efficiency Market Hypothesis and its Critics.” They state a company with a high P/E tends to underperform over a low one in the long term because the current stock price is over – or undervalued and may revert to long-term real value.
However, Mr. Ashwath Damodaran, author of “The Valuation of Equity Securities,” argues that the P/E ratio helps compare the valuations of different stocks but advises investors to use it with others, like company fundamentals and industry trends.
Before forecasting the company’s stock price, investors should consider other factors likely affecting the company’s future growth prospects, including the stock’s current price, earnings yield, expected growth, and company earnings.
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FAQs
1. What Does a Negative P/E Ratio Mean?
A negative P/E ratio means a company’s net profits have been at a loss for the past 12 months. 2 reasons may explain the causes.
The first is a growth company at an initial stage generating significant business volume. Nevertheless, the profit produced cannot offset the initial set-up and upfront costs, leading to a loss during the first few years of business. Investors are optimistic that the company will earn profits later despite negative P/ES in the first few years.
The second case occurs when a stock’s earnings remain in negative territory for a significant time, particularly for a company in a mature industry. Investors should stay alert on companies incurring losses at consecutive periods, ultimately leading to falls in prices.
“A negative P/E can be a sign that the market is irrational. However, it is important to be aware of the risks involved, as companies with negative P/E ratios may be at risk of further losses,” says Mr. Howard Marks, co-founder of Oaktree Capital Management.
2. P/E Ratio vs. Earnings Yield
Price-to-earnings ratio(P/E) and earnings yield(EY) are 2 popular tools for investment professionals. They both use the stock price and the earnings to measure companies. Yet, the interpretation and implications differ across the 2 ratios.
A P/E ratio, stock price divided by earnings per share, is a gauge of how investors are willing to pay for one dollar of earnings for a stock. A higher price implies that investors are inclined to pay more for a company’s stock due to the company’s growth prospects. A high P/E may also signal that a company is overvalued, leading to a subsequent price fall.
An EY is the inverse of a P/E ratio, dividing a company’s earnings by a stock price. It represents the percentage of return earned by investors on a one-dollar investment. A higher earnings yield suggests a higher return on investments paid. However, investors should look at whether the earnings are sustainable in the long term or an earnings surprise.
3. What is A Good PEG Ratio?
Another frequently-resort-to metric is the P/E-to-growth(PEG) ratio. It considers a company’s growth prospects by including a projected growth rate in the P/E ratio.
The PEG calculates a company’s growth by dividing its price-to-earnings by an expected earnings growth rate. The formula of PEG is P/E ratio/ g( expected earnings growth rate.)
Interpreting the PEG
A PEG of 1 suggests that the stock price meets the expected earnings growth rate. However, a PEG below 1 indicates that the stock price is undervalued; however, a PEG above 1 signals that the stock price is overvalued.
Pros
- Growth outlook comparison: The PEG ratio provides a more comprehensive comparison of growth rates across companies in an industry. That assists investors and analysts in identifying investment opportunities for undervalued and avoiding overvalued companies.
- In-depth analysis: Besides the P/E ratio, investors can compare companies’ growth rates and dig for solid investment opportunities through the PEG ratio analysis.
- Simple indicators: A PEG ratio offers a clear guide, where a ratio below 1 signifies overvalued status, a ratio of 1 is appropriately valued, and a ratio above 1 is overvalued, suggesting simple and easy-to-understand guidelines for making decisions.
Cons
- Subjective earnings growth rates: The projected growth rate is subject to individual judgments, preferences, and bias, likely to lead to substantial rate deviations from various sources. Finally, the differences in projected PEG ratios may make its usefulness absolute.
- Simple projection: With only 3 factors, the PEG ratio does not consider other essential things, such as a company’s financial soundness and industry trends, which tend to affect a company’s operating performance.
- Secor-specific: Like the P/E ratio, a PEG metric excludes industry or sector factors, making comparisons among industries meaningless. A PEG ratio comparison between a rapidly growing industry like technology and a maturing industry like utilities may mislead investors into wrong judgments.
4. Is 5 a Good P/E Ratio?
A lower P/E ratio usually indicates a stock’s undervalued status, presenting an investment opportunity. However, investors may consider other factors. One of them is industry.
Suppose a company in a technology sector has a lower P/E ratio of 5. In that case, it may offer an undervalued stock for investors expecting a surge in stock price in the future due to potential earnings growth and also facing a risk of loss thanks to competition.
5. Is a High P/E or Low P/E Ratio Better?
A high or low P/E ratio depends on factors such as company growth rates, industry prospects, and a company’s financial soundness. A company with a low P/E ratio compared to industry peers and a solid financial position in a fast-growing industry signals good buying time.
On the contrary, a corporation with a higher P/E ratio than others in a maturing industry may present a sell or avoid position to investors despite its healthy financial background.
6. Is a P/E 30 Good or Bad?
A P/E 30 is usually a higher metric, signaling an “avoid” position. The high ratio does not convey a possible fall in a stock price. Still, investors should embrace more risks encountered at such a high level in anticipating any price growth in the future than a lower P/E.
Final Thoughts
Whether a P/E is good or bad depends on a company’s growth prospects, financial health, and industry trends. A higher P/E ratio doesn’t indicate a possible fall in stock price, nor does a low P/E ratio guarantee a potential rise in stock price in the future. Investors should adopt an integrated approach, including P/E or PEG valuations, to make a reliable decision.
Key takeaways:
- A high P/E ratio signals that a stock may be overvalued.
- A low P/E ratio represents that a stock may be undervalued.
- In evaluating a stock’s P/E ratio, investors should compare it with the industry average and examine its financial health, growth prospects, and industry trends.
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