Unfortunately, there is no way to tell with certainty whether a given stock is a good buy (or whether it’s time to sell), but a stock’s price/earnings ratio can provide an indication of the value of that stock. The price/earnings ratio - or P/E ratio - is the most widely used yardstick for evaluating stocks. A stock’s P/E ratio is its current price per share divided by its annual earnings per share.
This ratio is a handy way to get at the heart of a business enterprise’s value, because it relates stock price to what business is all about - making a profit. You’ll find it represented as a trailing P/E, which conveys the stock’s price relative to its total earnings over the previous four quarters; or as a forward P/E, which looks at the stock’s combined estimated earnings over the next four quarters.
For example, say a stock is selling for $40 a share, its earnings over the last year were $4 a share, and it is estimated to earn $5 a share next year. Its trailing P/E is 10 and its forward P/E is 8. Put another way, it’s said that this stock is selling for a multiple of 10 times last year’s earnings and eight times future earnings. For this reason, the P/E ratio is also called a stock’s price multiple.
What You Can Learn From a Stock’s P/E Ratio
One way of looking at the P/E ratio is as a representation of how much investors are willing to pay for a company’s earnings stream. For a stock with a P/E ratio of 10, the market is saying it’s willing to pay $10 for each $1 of the company’s earnings.
By itself, the P/E ratio doesn’t mean much; its significance comes from comparing it to other P/E ratios, including:
- The stock’s prior or historic P/E ratio;
- The P/E ratios of other stocks, particularly those in the same industry; and
- The P/E ratio for the stock market as a whole.
Using P/Es to Make Investment Decisions
Comparing P/E ratios, you can start to evaluate whether a stock is underpriced (a good buy) or overpriced (time to sell it if you own it, or avoid if you don’t).
Let’s say a stock is selling today at a P/E of 15. Is it underpriced or overpriced? If over the last 10 years it has maintained a steady P/E ratio of 20, you might consider it relatively cheap and worth buying. On the other hand, if its average P/E ratio over the last decade is 10, it may well be overpriced now - not the time to buy.
A good P/E ratio is a relative term - dependent in large part on the industry the company is a part of. Companies in fast-growing industries, like technology, biotech, and pharmaceuticals, often justify high P/E ratios over 20, while companies in low profit margin, slow growth, or cyclical industries - food retailers, coal, and financial services - command lower P/E ratios, often in the teens or lower.
More recently, a related ratio has become increasingly popular among stock analysts: the price/earnings to growth, or PEG ratio. The PEG is calculated by dividing a stock’s P/E value by its projected average annual earnings growth rate over the next five years. Many experts believe the PEG ratio to be a more reliable measure of a stock’s price and value than the P/E ratio.
For example, a stock with a P/E ratio of 15 and an estimated five-year earnings growth rate of 15% a year has a PEG ratio of 1 (15 divided by 15). If its earnings growth rate is 10%, its PEG ratio would be 1.5 (15 divided by 10), while a growth rate of 20% would mean it has a PEG ratio of 0.75. Analysts believe that a PEG ratio approaching 2 means a stock may be overpriced, while a PEG ratio of less than 1 may represent a bargain.
A stock’s P/E or PEG ratio can be a helpful tool when making stock investment decisions. Please call if you’d like to discuss this topic in more detail.