Are you thinking about investing in the stock market? Or are you just an intrigued bystander trying to make sense of this technical and often confusing world? One thing that you will have to learn about is this phenomenon called the “P/E ratio”. People might hurl this term right at you so you best be prepared!
While it can sound tricky and confusing, we will dig deep into all its complexities and make sense of them. So read on to find out answers to some common questions like what is a good PE ratio and whether a high PE ratio is good or a low one.
Importance of the P/E Ratio
Before we get into the nitty gritty’s of what a PE ratio shows and what value is good or bad, let’s first understand what a PE ratio is in the first place and why you should bother learning about it.
In simple terms, the PE ratio is exactly as it states in the name: a ratio of price to earnings. When you buy a share in a stock market, you are essentially expecting to earn a certain amount from that share as a shareholder. Now, when you have a rough figure for what your expected earnings per share are (EPS), a PE value could be determined for how much you are paying for said earning.
So that explains what P/E ratios are at their core. Now it’s important to understand why you need to care about them. This takes us to the point when you will be choosing which shares to buy. Here you have to start comparing different P/E ratios to see which one is the most ideal for investment. It’s also important to understand that the other stocks you compare P/E scores with are of the same industry.
The higher the better?
P/E ratio is important in many ways to help compare different stocks, but what does that comparison look like? Is a high PE ratio better? It’s quite the opposite. Mathematically speaking, if the price for a stock, stock A, is higher than stock B, while the earnings per share (EPS) are lower than that of B, then you’ll be better off with stock B. In other words, you are paying more for the same earnings per share in A than in B.
However, that’s not the end of P/E ratios. There’s much more to be understood about P/E values to see what they actually mean for you and your investment shares.
Absolute vs Relative P/E
When you come across a P/E value, one thing you should find yourself asking is whether it is the Absolute P/E value or the relative one.
In an absolute P/E value, the ratio has the price you pay in the numerator and the estimated EPS in the denominator. Alternatively, sometimes the EPS is replaced with the trailing EPS (aka TTM) or a combination in which the initial quarter values are from the trailing earnings per share while the latter is from the future estimated EPS.
On the other hand, relative PE values are ones that compare different PE values across time periods. One element that is taken into consideration here is relevance. For instance, if the economic conditions were only relevant over the last 10 years, then only PE values from that period of time will be taken into consideration. The way this comparison is done is that either the highest or the lowest PE value from the past is compared to the absolute PE value to see how the stocks are holding up. (Highest is taken to see how well the stocks are doing while a low is used to see how close to the all-time low the stocks are).
Industry P/E Ratios
Industry PE’s are another term you’ll hear about a lot. This refers to a specific industry like the US motor or auto manufacturers and determines the average P/E in that industry. The way this is calculated by using the P/E values of the companies that comprise or function in this industry. This value allows you to see how each company is fairing in the market against all their competitors.
For example, if a certain company has a higher P/E value than the industry P/E value, then you can make one of two inferences: Either you can say that this company is overvalued because its earnings per share are much less in ratios to the price you have to pay, or you can say that investors are willing to pay a high amount in order to get the company’s stock. The latter would mean that the investor believes lies in this company, and that might be a guarantee that it is a safe bet.
Historical P/E Rations
Experience is indeed the best teacher and it is in the pages of history that we can find the most reliable answers. The same applies to stocks and p/e ratios. Historical PE ratios are documented for the Standard and poor’s 500 companies and they show they can be used to make predictions about the ongoing trends in the market. These values were being recorded as early as the 1800s, and our data puts the average at 16. However, we have observed lows as low as 5 and highs as high as 124!
The general idea is that when the economy is doing well, the numbers go up because more people are willing to pay for it despite the high P/E ratio. On the other hand, people become hesitant to make such moves in times of crisis which drags the charts down.
The Math behind the P/E Ratio
Figuring out how the P/E ratio works mean understanding what happens when you buy a share of a company. At its core, a P/E value is what you are expected to pay for purchasing 1 dollar worth of the company’s earnings at a given time.
The formula is simply as follows: P/E ratio = Price of Stock / EPS
You might be familiar with the stock price, but the EPS is a little more complex. This value takes the total earnings a company had in either the trailing (or past) fiscal year or predicts/estimates one for the upcoming year. Then the total earnings are divided by the number of shareholders that exist.
If that went over your head, don’t worry. You won’t need to calculate these yourself.
Industry P/E Ratios
Here I want you to think like an investor. When it comes to investing in a particular stock, you are going to want to pay more for a stock that you expect to do better. This means, on a larger scale the stocks for this industry will have a higher P/E value than ones that are expected to have less demand.
Case in point, in times of crisis like the Great Recession, it was fair to assume that people would value household staples like bread, toilet paper, or water over more luxurious or unnecessary items like tech stuff. That’s exactly what happened, and staple good stocks had a much higher P/E ratio.
Essentially, all this is a game of expectations. The parts of the economy investors find to be a good investment are going to have a higher share price. This is because they expect a profitable earnings yield from this investment in the future.
Trailing P/E vs Forward P/E
Another classification that you need to be familiar with is trailing and forward P/E ratios, where the former is traditionally used. The difference here is simple. As the name suggests, the trailing P/E value uses the economic yield from the last 12 months (hence the term “trailing”) while the forward P/E ratio is based on the predicted earning for the coming months.
There is no “good P/E ratio” here. There are pros and cons of both, and you need to consider those when choosing which P/E ratio to use. Trailing is more reliable because it is data of what happened, but there’s no saying how the winds blow in the future. Similarly, the Forward P/E ratio accounts for the most recent circumstances but fails in its accuracy because it is a prediction after all.
Reading the P/E Value
The P/E ratio isn’t a value you can blindly take to be a good or a bad one. It can only be used in the right context, being compared to the right companies. And it can only be used to make inferences about things like the company’s earnings, net income, expected earning’s growth rate, and even the overall market.
Most importantly, however, this gives you insight into the perspective of the investors and who they believe will succeed in the current economy.
The question of what is a good PE ratio is too simplistic. A high PE stock would mean you are paying more than the EPS, but we see big corporations like Amazon have PE ratios leagues beyond their competition in eCommerce.
What does the P/E ratio say about stock value?
With all this information, let’s piece together how you can determine the value of a stock from its P/E ratio.
P/E vs PEG Ratio
P/E ratio is usually used together with P/E to growth ratio i.e. PEG ratio. This also factors in the foreseeable growth.
P/E vs Earning Yield
If you flip the values around and right it as E/P, you are essentially calculating your earnings from a share with respect to the price you paid. Sound familiar? This is essentially the percentage of the amount you get back from your initial amount.
P/E Ratio Holes
One obvious flaw within all of this is that companies have the keys to the figures and data. They can control what investors see are the earnings and the shares. This can lead to inflated earnings yield to steer people’s expectations.
Become an improved Investor
The stock market is a massive industry that has been around for a while. One key to becoming an improved investor is to reach out for professional advice. Talk to financial advisors who have much more hands-on experience.
In conclusion, P/E ratios are an incredibly useful tool in seeing how a company is faring in the market. They also allow us to make predictions about how our investments will do with different stocks. But it all comes down to using the value in the right context. So what is a good PE ratio? Bottom line is, it depends!