Understanding the Value of a Good P/E Ratio

On August 1 of this year I invested $25,000 in Ford (ticker: F) based largely on its low P/E Ratio (price to earnings ratio). In three months, the stock price has risen about 25%, bringing the value of my investment to more than $30,000.

Of course, short term gains or losses are not the true measure of an investment. We’ll see how the stock is doing in 25 years to better assess the real quality of the investment. But it does give us an opportunity to look at the P/E ratio and to understand how it can inform our investing decisions.

Used correctly, and the P/E ratio can help you determine whether a stock is over or undervalued. Used incorrectly, however, and like the Pied Piper it can lead you astray with disastrous results. So today we’ll look at what the ratio is, how it’s calculated, and how you can use to make sound investing decisions.

What is the P/E Ratio

The P/E ratio is simply a comparison of a company’s per share price to its per share earnings. For example, a company trading at $10 a share and earning $1 per share would have a P/E ratio of 10 (10 / 1). If the company’s stock price jumps to $20 a share, its P/E ratio would rise to 20. In contrast, if it’s stock price dropped to $5 a share, its P/E ratio would drop to 5. If the company’s earnings per share rises to $2 and its stock price remains at $10, its P/E ratio would drop to 5 (10 / 2).

If you’ve been following along, you know that the P/E ratio moves in the same direction as the stock price and in the opposite direction of earnings per share:

  • As the stock price goes up, the P/E ratio goes up
  • As the stock price goes down, the P/E ratio goes down
  • As a company’s earnings go up, the P/E ratio goes down
  • As a company’s earnings go down, the P/E ratio goes up

The P/E is also referred to as the “multiple,” because it shows how much investors are willing to pay per dollar of earnings. If a company is trading at a P/E multiple of 15, the interpretation is that an investor is willing to pay $15 for $1 of current earnings.

In the investment community, companies with higher P/E ratios are more likely to be considered “risky” investments than those with low P/E ratios, all other things being equal, because a high multiple signifies that the market has high expectations for the company, and therefore, the stock.

In other words, a higher P/E ratio means that investors are willing to pay more for each unit of net income, so the stock is more expensive compared to one with a lower P/E ratio.

If all this seems a bit convoluted, there is an easy way to interpret this ratio. The P/E ratio always equals the number of years it would take in earnings per share to equal the current price of the stock. So if the ratio is 20, it would take 20 years of current earnings to equal the current price of the stock. Think about that the next time you buy a stock with a P/E ratio of 200!

How is the P/E Ratio Calculated?

While it first glance the price-to-earnings ratio seems simple, there is actually a lot more to this comparison than meets the eye. To get a valid P/E, you need to right data. So let’s take a quick look at each component of the ratio.

Price

Price seems simple. Just take the current price of the stock. For most stocks it is that simple. Ford, for example, is an actively traded stock, so you can be confident that the stock price reflects the market’s assessment of the value of the company.

For thinly traded stocks, however, the price may not be reflective of the company’s value. So if you are evaluating small companies with little trading activity, think carefully about the price component of this ratio.

Earnings

Earnings can be more of challenge. Do you use earnings from the last twelve months (called trailing twelve months, or ttm for short), projected earnings for the next twelve months, or something else?

When I look at the P/E ratio, is use ttm earnings. The business of estimating future performance of a company is tricky at best. Considering a company’s future prospects is important, but relying on historical performance as a starting point for the analysis avoids the guess-work.

Why Compare Share Price to Earnings?

Before we turn to how you can use this ratio in your investing, it’s worth asking why we compare share price to earnings in the first place. Let’s first answer that question in the context of a small business.

Imagine you run your own business from your home. You generate revenue, pay out expenses, and pocket what is left. Your earnings are the critical financial component for the success of your business. While higher revenues may be a goal, they do you little good if your expenses go up by the same amount. In other words, it’s what you keep after expenses that matter.

The same is true with large, publicly traded companies. While as investors we don’t have direct access to a company’s earnings, that is ultimately what we are investing in. And that raises a question–how much should we pay for a company’s earnings? That question, in turn, brings us back to the P/E ratio. The higher the P/E, the more we are paying for that company’s earnings.

Is the P/E Ever Too High?

The stock market has various interpretations of P/E ratios. It is most useful when analyzing P/E ratios to compare apples to apples, i.e., comparing the P/E ratio of a car manufacturer and a technology company is not useful as these industries are completely different.

The historical table below is only indicative and cannot be a guide, but may help to guide an investor’s thought process and put their interpretative capabilities on track. It should be noted that P/E ratios should be considered in light of the economic environment and current interest rates.

  • N/A – A company with no earnings has an undefined P/E ratio. This would usually be ascribed to a company with negative earnings.
  • 0–10 – The stock may be undervalued or the company’s earnings are declining. Alternatively, current earnings may be substantially above historic trends or the company may have profited from selling assets.
  • 10–17 – For many companies a P/E ratio within this range may be considered fairly valued.
  • 17–25 – The stock may be overvalued or the company’s earnings have increased since the last earnings figure was published. The stock may also be considered a “growth” stock in which earnings are projected to increase over some future time period.
  • 25+ – A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble.

(Source: Wikipedia)

Investors should not base an investment decision in a company on a P/E ratio alone as there are several other ratios and parameters that can be examined to determine the health of a company and its future sustainability and success.

The P/E ratio can be manipulated, unfortunately, as the calculation of a company’s earnings (part of the EPS in the denominator) is not straightforward. Earnings can be “massaged” to make the picture look better or worse to the investor. Earnings can also be affected by one-time events.

Therefore, as with most ratios, the quality of the P/E is only as good as the quality of the underlying earnings number. It is important to do your homework thoroughly before you invest and choose and online discount broker with resources that can help you out.

How I Use the P/E Ratio

Recently I relied heavily on the P/E of Ford (ticker: F) to invest in the auto maker. At the time of my investment, Ford’s P/E ratio was less than 2. In contrast, most other major automobile manufactures were selling at multiples above 10 (GM trades at about 9 times earnings; Toyota and Honda at about 13).

But before I made my investment, I tried to understand why Ford was selling at such a low multiple as compared to the industry. If you did that research today (just search Google for “why does Ford trade at a low pe ratio”), you’d find some excellent information on Seeking Alpha. In this article by Blake Morgan, he points out that much of Ford’s recent earnings came from a one-time event. Excluding those earnings increases Ford’s P/E to just over 7. Perhaps still a good investment, but a lot higher than a P/E of 2.

In my analysis, I have confidence in Ford’s management and like the cards the company has been producing. While Ford still has a long way to go, I’m optimistic about its future. Couple that with a relatively low stock price relative to earnings and its dividend yield, and I took the plunge.

Is a company’s stock price as compared to earnings the only factor to consider? Absolutely not. In fact, in most cases it’s not even the most important factor. But it does give you a measure of a company’s price relative to other companies in the same industry.

It can also help you avoid expensive companies. I really want to invest in Amazon. But with a P/E ratio north of 3,000(!), I just can’t bring myself to make the investment.

Published or Updated: April 4, 2013

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