Why do investors put so much significance on company's PE Ratios?
A price to earnings ratio, known as a PE Ratio, is one of the most widely used, quick, and easy metrics to select a stock. A simple calculation of a PE ratio is to divide the current market price of a stock by the company’s earnings per share.
Where, When & How to correctly use PE Ratio
PE Ratios are best utilized when compared to competitors in the same sector or industry. It is not helpful for example, to measure the PE Ratio of a technology company with the PE Ratio of a Consumer Staple. These two sectors have vastly different growth projections and expectations.
Each industry typically has a PE Ratio range that is considered normal. The correct way to think about PE Ratios is to view the industry or sector from a long term historical average perspective (the longer the better). If the long-term average of a sector or industry has a PE ratio of 15x and company A is trading at a PE Ratio of 20x that may suggest the company is currently overpriced. On the other hand, if company B in the sector is trading at a PE Ratio of 10x that may be an indication that the company is undervalued now.
It is important to note that just because a stock is cheap it doesn’t mean you want to invest in it. It is vital to do your research and figure out the reasons why the company is trading where it is. Is it because the market itself collapsed, or a competitor just came out with earnings and missed badly, essentially affecting all companies in the sector. It can happen. Did management misjudge something about the business? There are a whole host of reasons why a company is trading at a price.
At the end of the day, investors want to know how profitable a company is and what future profitability looks like. The PE Ratio is an earnings multiple, generally you will see a Trailing PE, meaning a previous time frame of actual earnings (for example a 12-month trailing PE) or a forward PE Ratio, which is predicting future earnings. Forward PE Ratios are assumptions into the future earnings of the company.
Using PE to categorize a stock as Value or Growth
It is not uncommon for companies that have a high PE Ratio to be considered a growth stock. It is important to keep in mind that growth stocks can often be accompanied with high volatility, meaning there can be big swings, both up and down, in the price of the stock. Stocks that are trading at a low PE Ratio are often thought of as value stocks. Again, deeper research is needed to unravel the reason behind a low PE Ratio. Companies that trade in mature industries and have a long history of steady dividends can often trade at a low PE Ratio. The company may be quite sound and a reasonable investment but because it is expected to grow slowly because of its industry, that is important information to be aware of.
PE Ratios are a good starting point, but that’s it, the trend of those price to earnings is important, along with comparing those earnings to apples to apples competitors, those type of comparisons are even better. One must dig into the company’s financial statements to get a good sense of the true strength of future earnings. We have a whole series of videos analyzing company financials from “how to read a cash flow statement” to what is the Weighted Average Cost of Capital (WACC), to tutorial on reading a simple income statement. There is also a video on the 4 key ratios every investor should know.