Why Investors Care about the P/E Ratio
The P/E ratio tells investors how expensive a stock is compared to its earnings or profits. It can be used to compare stocks in a similar business or industry group but it’s not as helpful when comparing stocks in very different industries. Investors who are concerned about getting a good value try to avoid buying a stock when the P/E ratio is very high compared to its peers. A stock can also be unattractive when its P/E ratio is much higher than it has been in the past.
How the P/E Ratio Works
The P/E ratio stands for Share Price divided by Earnings Per Share (EPS). The (ttm) following the ratio stands for Trailing Twelve Months, which means the last 12 months of EPS are used in the calculation. Imagine that a stock was trading for $40 per share and the total earnings per share over the last 12 months was $1.60. From that information you would know that its P/E ratio was 25 ($40 ÷ $1.60 = 25).
One way to think about the P/E ratio is that it tells you how much investors are willing to pay to “buy” the profits of a company. In the previous example, investors are willing to pay 25 times the annual profits of the company to buy ownership through shares. The flaw in this example is that the shareholder doesn’t actually get all of those profits (although some of it might be returned in the form of dividends).
The P/E ratio will change on a day-to-day basis because the stock’s price is one of the factors used in the calculation. The EPS for a company will only change once per quarter when new earnings reports are released. If earnings change dramatically from one quarter to the next the P/E ratio could change very quickly, but that kind of change will be rare.
Select two stocks that are in the same industry group and fairly correlated. If you don’t have two to start with then use LOW and HD, two stocks in the Retail/Hardware Store category. Find both of their P/E ratios and see which is lower. Has the stock with a lower P/E ratio outperformed the other over the last year?
Although P/E ratios are a very small window into the performance of a company they can still be useful. Some investors will use measures like the P/E ratio to compare stocks within the same industry group. Assuming all else is equal the stock with the lower P/E ratio may be considered a cheaper stock or better value.
P/E ratios can also help you identify companies that are considered growth stocks versus the so-called “blue-chip” or defensive stocks. Stocks with very high P/E ratios relative to the market averages are priced that way because investors expect that future earnings will be much higher than the earnings seen over the last 12 months. Blue chip or defensive stocks will usually have a much lower P/E ratio because growth expectations are lower for the future. You can include those growth expectations in the P/E ratio to help compare slow growing and fast growing companies.
Improving the P/E Ratio
Adding growth to the P/E ratio turns it into the P/E/G or “peg” ratio. To calculate a P/E/G ratio take the stock price divided by the last 12 months of EPS plus the projected growth rate for the next five years. For example, imagine a stock with share price of $40, EPS of $1.60 and expected growth of 30% over the next five years. That stock’s P/E/G ratio would be 1.27 ($40 ÷ $1.60 + 30 = 1.27). Traditionally a P/E/G ratio near 1 is considered fairly valued while greater 1 one is over-valued and less than 1 is under-valued.
As you can see in the previous image, the PEG ratio is available on the right side of the Summary page under the chart and Key Statistics. Compare the PEG ratio of the two stocks you selected in the first exercise and see how they compare. Did the relative value between them change? If you were making a choice between the two stocks would your opinion change now that you know more about growth estimates?
The P/E ratio has its limitations but it can be useful as a way to think about the value of a company relative to its earnings or profits. It is sometimes used to compare two very similar stocks to determine which is the better value but should not be used by itself. The greater the P/E ratio the greater the growth expectations, but it is also likely that those stocks will also experience greater volatility in a bear market.
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