The price-to-earnings ratio has its critics, yet it remains a metric worth watching for valuing stocks and making investment decisions.
Price-to-earnings ratios can provide some context to identify the potential value of a company
Price-to-earnings ratios may help you determine whether broader market indices could be overvalued or undervalued
It’s arguably the granddaddy of all the market metrics to determine expensive versus cheap, but the price-to-earnings ratio (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 myriad 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 price-to-earnings 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 from TD Ameritrade—can offer valuable context (see figure 1).
If that $100 company earned, for example, $4 per share in the past year, that’s a P/E of 25—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.
FIGURE 1: CRUNCHING NUMBERS. Current and five-year average P/E ratios can be accessible through thinkorswim. Navigate to the Analyze tab, type in the stock symbol, and then head over to the Fundamentals tab. Chart source: The thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
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:
TRAILING P/E is based on the past 12 months’ per-share earnings; these financial results have already been reported by the company and are likely reflected in the stock price. When you hear media mention P/E ratio, it’s likely to be the trailing P/E ratio.
FORWARD P/E, also known as expected P/E, uses the average analyst per-share profit estimate for the coming 12 months; many market professionals favor the forward P/E ratio, which is considered more of a leading indicator that can foreshadow share price moves.
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 Standard & Poor’s 500 Index averaged 16.3, according to S&P Dow Jones Indices, compared to its historical average 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.
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).
FIGURE 2: HOW HIGH IS HIGH? The Scan tab on thinkorswim can provide a list of companies that meet your scan criteria. Some may have triple-digit P/E ratios (yellow box); still, such lofty numbers don't necessarily mean a stock is "overvalued" or that it won't go higher. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
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 that when people have to start making up new calculations to justify current valuation of a stock, a sector, or the market in general it might be a sign of a top.”
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Doug Ashburn is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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