The Curious Investor

The Price-to-Earnings Ratio (P/E ratio for short) is, very simply, the price per share divided by earnings per share (EPS) hence P/E Ratio. Basically, what it is showing is how much investors are willing to pay for a stock per dollar of earnings. A stock with a high P/E ratio would imply that investors believe that there will be greater earnings growth as opposed to another stock with a lower P/E ratio.

Well, the P/E ratio seems simple enough, right? Given the definition above, we could come to the conclusion that, unless a company has very high earnings growth and strong projections, we always want to buy stocks with the lowest P/E possible. This, however, is not the case. P/E is a helpful tool in stock analysis but not meant to be the only tool.

First and foremost, P/E ratio is only as good as the earnings number that was used to compute it. For example, when you check newspapers and financial websites for a company’s P/E ratio, you might be confused as to why P/E ratios don’t seem to be the same in all publications or why you might see different types of P/E ratios called “Trailing P/E” or “Forward P/E.” This is because the method of calculating earnings can vary from site to site. Most of the time, earnings are calculated as the total earnings in the last four quarters. This type of P/E ratio would also be called a “trailing P/E” since it is comprised of information from the trailing four quarters or trailing twelve months (TTM). As you may be able to guess, forward P/E is based on estimated earnings for the next four quarters. Both TTM earnings and earnings forecasts are succeptible to all sorts of manipulation and it is important to be sure of the source and accuracy of these numbers.

Another issue with P/E ratios is that they are not really meant for making broad based comparisons. One should really only use P/Es to compare similar companies (i.e. those within the same industry possibly even of similar size). This is because, as stated earlier, P/E tells us how much we have to pay for each dollar of earnings of a stock and, as a result, low P/Es are only “low” if there is potential for earnings to grow in the future. Growth potentials, obviously, are different from company to company and differ significantly from industry to industry. As a result, it is impossible to make a broad statement like saying, “All stocks with P/E ratios less than 20 are cheap and buyable.” Instead, judging the “lowness” of a P/E ratio is really more based on intuition and it’s lowness relative to the company in question’s P/E history and P/Es of similar competitors.

So, what should we do with the P/E ratio? The P/E ratio is one of the most talked about and most heavily hyped stock valuation statistics and should definitely be considered whenever you are making a stock pick. What we should look for is “low” P/Es relative to a company’s industry and likely to its own historical averages. If these two criteria are met, then one could say rather safely that the stock is trading at a discount. That being said, a stock trading at a discount is often trading at a discount for a reason - nobody wants it. As a savvy and informed stock investor, it is your job to find out, through other research, why. If you can identify this reason and are comfortable that growth prospects are still strong despite whatever reason has depressed the stock’s P/E recently, then buy away!

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