The price-to-earnings ratio can help investors assess a stock’s value, albeit with limitations.
Some people are “numbers people,” meaning they like when they can solve problems with a concrete number. A numbers person might be attracted to the price-to-earnings ratio, since it’s a mathematical formula to help assess the value of a company’s stock. This ratio can illustrate how much investors are paying for each dollar of earnings.
Unfortunately for people looking for a numbers-only answer, the ratio alone doesn’t necessarily tell the whole story of a stock’s value. Still, the formula can be a useful starting point for valuation.
WHAT IS A PRICE-TO-EARNINGS RATIO?
The price-to-earnings ratio is the ratio of a company’s stock price relative to that company’s earnings per share (EPS). The price-to-earnings ratio is also known as the P/E ratio, the P/E, or the PER.
An investor can compare a company’s P/E ratio against itself (by comparing recent data with historical data) or against other companies in the same industry. This mathematical formula can help investors better understand the value of a stock. However, although this formula can be convenient, it doesn’t provide the full context for assessing valuation.
But before we discuss the limitations, let’s break down how to find the P/E ratio.
HOW DO YOU CALCULATE THE P/E RATIO?
To calculate the P/E ratio, divide the market price of a share by the EPS. The EPS is the portion of a company’s profit allocated to each outstanding share of common stock. EPS can indicate a company’s ability to produce net profits for common shareholders.
WHAT IS A GOOD P/E RATIO?
Is there a good P/E ratio? That depends on the industry of the company in question.
Some sectors have a higher average P/E ratio than others. For example, according to January 2021 data published by Stern's Center for Global Economy and Business at New York University, the current P/E ratio for the apparel sector was 22.38; meanwhile, the P/E ratio for the telecommunication services sector was 158.41. Investors may have a better idea of how high or low a P/E ratio is for a company in the apparel sector by comparing it with its competitors, rather than following the expectations of a different sector.
A low price to earnings ratio can be appealing to value investors, who are looking for quality stocks at bargain prices. Value investors hope to find companies that have solid fundamentals but whose shares are valued lower than what they think they should be, since they anticipate those companies’ stock price will rise.
On the other hand, some investors prefer a strategy that focuses on growth investing. This means they look for companies with a high P/E ratio, because they see the high price as an indicator for future earnings growth. However, these kinds of stocks may be overvalued and can have higher volatility, which means they might be a risky investment.
Considering these variables, whatever you consider a “good” P/E ratio depends on the context of the industry as well as your individual strategy.
WHAT ARE THE LIMITATIONS?
A P/E ratio can be a helpful initial tool for assessing value, but it relies on other pieces to complete the puzzle. For one, P/E ratios are based on company earnings, which don’t necessarily reflect the strength of the company. Extraordinary circumstances outside the company’s fundamentals can affect a company’s earnings report. By way of illustration, you wouldn’t judge the quality of any of the most recent Tony winners by how many performances they had on Broadway, since COVID-19 forced theaters to close in early 2020.
Secondly, by comparing P/E ratios against other companies’ ratios, investors assume the earnings reports are presented by their companies in the same way. In fact, different accounting methods can distort the bottom line that a company reports. Moreover, a P/E ratio doesn’t account for a company’s debt, which can affect the overall profit.
Finally, there may be a discrepancy between the timing of the data. The stock price is updated daily, but the P/E ratio may rely on historical earnings from the company’s latest published income statement. That data may be up to three months old, since companies report them quarterly. In addition to the difference between the daily stock price and quarterly earnings reports, historical earnings don’t necessarily say much about future earnings.
This can be tricky for investors who are most interested in a stock’s future performance. Investors could examine forward earnings, which are an estimate of future revenues and other financial data by analysts. However, forward earnings are not always accurate predictions.
Although a P/E ratio may be a helpful tool, you should never rely solely on a P/E ratio when determining the value of a stock. Researching the context of the data and using other technical assessments can provide a better understanding of stock valuation.
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