The price-to-earnings ratio has its critics, yet it remains a metric worth watching for valuing stocks and making investment decisions. Learn more in this article.
It’s arguably the granddaddy of all the market metrics to determine expensive versus cheap, but the price-to-earnings (P/E) ratio has been (and probably always will be) a subject of hearty debate. Does P/E still matter? Yes, many experts say, but . . .
It all starts with some simple math that a typical sixth-grader could handle. Take one number (the current price of a stock, in this case) and divide it by another (earnings per share for a full year). Voilà, there’s your P/E ratio.
If only it were that cut-and-dried. But it isn’t, and the subject is complicated by a myriad of other valuation models, financial media talking heads, and everything else that swirls around an investor’s brain every day. But understanding how P/Es work, and keeping your eyes open for the stories these numbers tell about a business or market, is still important for almost any investment or trading plan. So, what is the P/E ratio, really? Let’s break it down.
A stock price by itself doesn’t convey the entire picture. Just because XYZ Corp. is trading at $100 per share and ZYX Inc. is at $10 doesn’t necessarily mean XYZ is a better investment that offers strong growth prospects and astute management. Here, P/Es—along with other fundamental company information available through the thinkorswim® platform—can offer valuable context (see figure 1).
For example, if that $100 company earned $4 per share in the past year, that’s a P/E of 25—which could be possibly “overvalued,” depending on, among other things, how that stacks up against industry peers. If other companies in the same industry have P/Es closer to 18 or 20, the $100 stock may be a bit expensive relative to its competitors. And that may mean limited upside potential, or that the stock may be poised for a decline. Tread with caution.
By the same token, the $10 company that earned $1, for a P/E of 10, could be “undervalued,” meaning investors aren’t showing it enough love given its relatively healthy financial condition. A good rally prospect? So-called value stockpickers often hunt for low P/Es, along with other signs the shares may command a higher price in the future.
P/Es can also be applied to the broader market, providing both history lessons and harbingers of potential turning points. Over the past three years, the trailing P/E for the S&P 500® index averaged 16.3, according to S&P Dow Jones Indices, compared to its historical average of around 15.
The market can spend long periods at high P/E levels before returning to historical norms. That’s what happened before and then after the dot-com bubble in the 1990s and early 2000s. Conversely, after the 2008 financial crisis, the market snapped back relatively quickly after sinking to the lowest P/Es in decades.
P/E ratios, also known as P/E multiples, measure how much investors are willing to pay per dollar of a company’s profits. The ratios are typically calculated two different ways:
Over the past couple decades, those who would deign to dis P/Es gained ammunition as the internet revolution gained momentum, altering perceptions on what should and shouldn’t be “valued.” Everyone was latching on to that “next big thing” where “eyeballs” and “page clicks” trumped good old-fashioned revenue growth and profit margins, or so it seemed.
To detractors, P/Es and other traditional valuation metrics are simply out of step with the modern digital era, failing to account for the rapid growth of many new technology companies. A quick check using the Scan tab on thinkorswim reveals dozens of social media companies, online retailers, and other similar names with P/Es well into the triple digits (see figure 2).
Does that mean these stocks are overvalued? Not necessarily. In many cases, high P/E companies are accompanied by solid earnings and revenue growth and the hope of more for years to come (companies that are losing money don’t have a P/E, by the way).
Given the large number of stocks with high P/E ratios, does valuation carry much weight? P/E ratios provide an indication of a company’s prevailing earnings. Even forward P/E ratios, which are merely estimates, don’t necessarily say anything about a company’s potential growth. Another point to note: P/E ratios don’t take the cyclical nature of different industries or variations among industries into account in their calculations. Comparing the P/E ratios of an online retailer to that of an industrial manufacturing company is like comparing apples to oranges.
Wherever you plant your flag in the P/E debate, there seems to be at least one common thread among many market watchers: You can’t disregard these numbers altogether.
Valuation still has a place. Businesses exist to generate cold, hard profits, after all, and over the long term, the markets sort out who’s doing the best job at that, and who isn’t.
“Many investors, from the professional to the individual, are still fans of monitoring P/E ratios,” said Ryan Campbell, senior content producer at TD Ameritrade. “I do think investors are still using P/E as a harbinger of overvaluation. I also think when people start making up new calculations to justify the current valuation of a stock, a sector, or the market in general it might be a sign of a top.”