Price/Earnings Ratio Explained

How Does P/E Affect a Stock's Value and when is a High P/E Too High?

Price/Earnings Ratio Explained
April 24, 2014

The Price-to-Earnings (P/E) Ratio is one of the most often quoted measures of the value of a stock, but it can be puzzling to the novice investor. Stocks at a high P/E ratio may be considered a good deal, and stocks with low P/E ratios may be considered a poor deal, seemingly contrary to logic. What does the P/E ratio really mean, and how can you determine whether a stock with a high P/E ratio is worth purchasing?

The P/E Ratio is defined as the price per share of common stock divided by the after-tax earnings per share (EPS). In essence, this tells you how much investors will currently pay for every dollar of company earnings. It is also known as a stock multiple, since this is the multiple of earnings that investors will pay for a particular company's stock.

Is a stock with a high P/E value inherently overpriced? Not necessarily.

The Impact of P/E on a Stock's Value

First, not all P/E ratios are the same. Price is immediate, while earnings are time-based (usually a quarterly or annual value). A popular method of calculating P/E ratio uses earnings from the previous four quarters, otherwise known as TTM (Trailing Twelve Months). While that provides an accurate curve of the past, there is no guarantee that earnings will continue on that path.

A "forward" P/E ratio uses estimated projections of earnings over the next 4 quarters. This tells you what you need for investment purposes, but you are completely dependent on the accuracy of the forecast. Dig into any forward P/E to determine what assumptions are made, and who is doing the assuming.

So if a company's stock is at a high P/E ratio but is considered an attractive investment by professionals, what does that mean? Simply put, they expect continued company growth. Conversely, a low P/E that is not considered a bargain indicates that investors expect poor growth. In these cases, the past growth rate does not match investor's future expectations.

How High is too High?

This phenomenon is tracked by the Price/Earnings to Growth (PEG) Ratio; the P/E ratio divided by the estimated growth in earnings per share. However, PEG is equally dependent on correct estimates of earnings and growth.

A good way to determine whether a P/E is too high is to compare a company's P/E with those in a similar industry, specifically competitors. Even in a completely overvalued market, like tech stocks during the bubble, relative P/E comparison can help you find the lower P/E stock and therefore the most likely good deal – but you still have to take into account future growth.

An extreme market in either direction can make P/E ratios hard to read. In a badly sagging market, earnings may be falling but prices may be falling even faster. Be sure to look at P/E trends and the overall market direction.

If a P/E ratio seems out of line, look at the fundamentals. Earnings can be manipulated, but cash cannot. Some analysts prefer to look at a company's cash flow and/or Price-to-Sales (P/S) ratio to make sure they line up with reported earnings. It is also good to check for excessive debt.

Do Your Homework

While the P/E ratio is useful, it can be misleading by itself. Make sure you know how a P/E is defined, investigate estimates of growth, and check other fundamentals such as cash flows, P/S ratios, and debt. With the extra information, you should have a pretty good idea of whether a P/E ratio is inflated – at least as good of an idea as the rest of us.

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