Is a stock a bargain or overpriced? This is a basic question for every investor, and there are any number of ways to answer it. But one of the best places to start is by looking at what is known as the price-to-earnings ratio, a yardstick that every investor should be familiar with and understand.
What is a price-to-earnings ratio?
A price-to-earnings ratio, or P/E, refers to the relationship between a company’s stock price and its earnings, or net income. It’s also referred to as the price-earnings multiple because the stock price will usually be several times more than earnings.
The P/E ratio answers this question: how expensive is the stock price, relative to the company’s profitability? The ratio is also used for sectors—companies grouped by same or similar industries—and for broader market indexes such as the Standard & Poor’s 500 and the technology-heavy Nasdaq.
How to calculate P/E ratio
Here is a simple example of how to calculate the P/E ratio: Company A’s stock price is $120, and its earnings for the most recent four quarters were $6 a share. The price-to-earnings ratio is:
120/6 = 20
This means that an investor is willing to pay 20 times the amount of Company A’s earnings to own a share—or said another way, an investor is willing to pay $20 to own a claim on a dollar of the company’s earnings. The price-earnings ratio, then, is investors’ collective opinion about a company’s profitability.
An investor uses P/E comparisons to determine how expensive a stock is, relative to other stocks, to the stock’s sector, or to broader market indexes. If Company B’s current stock price is $90 and its recent earnings were $3 a share, its P/E ratio is:
90/3 = 30
So even though a share of Company A nominally costs more, it’s less expensive than Company B from a relative price-earnings basis.
Inverse of P/E: Earnings yield
The inverse of a P/E ratio is the earnings yield—earnings divided by price in percentage terms—and investors sometimes use this comparison as well. For Company A, earnings yield is $6/$120 = 0.05 or 5%. For Company B, the yield is $3/$100 = 0.0333 or 3.33% . Company A again looks like a relatively better bargain. Earnings yield is merely an upside-down way of looking at the P/E ratio.
What’s a good P/E ratio?
The key word for answering the question, “What’s a good P/E ratio?” is it’s all relative. A price-earnings ratio in isolation means little. It must be considered relative to a number of other things. These can include:
- Other companies’ P/E ratios. For example, the P/E ratio of a company such as ExxonMobil’s could be compared with Chevron’s P/E.
- Industry averages. Using the same company, an investor might compare ExxonMobil’s P/E with that of the energy sector’s average P/E.
- Historical average. ExxonMobil’s current P/E could be compared with its historical average, giving an investor insight into whether the share valuation is higher or lower than in the past.
- Markets. An investor could compare a company against the broad stock market—ExxonMobil’s P/E against the S&P 500’s ratio. Sector and index P/E ratios can be compared as well; the energy sector against the health-care sector, or the S&P 500 against the Nasdaq Composite.
Some companies may show N/A for price-earnings ratio, meaning not applicable, or a negative sign in front of the ratio. That means the company had no earnings, or that it reported a loss. Typically, N/A will appear, rather than a negative ratio.
A company can have a bad year and then recover, restoring its positive P/E ratio. But repeated losses indicate higher risk because investors don't know if the company will ever become profitable again. Then again, look at Amazon. Founded in 1994, it didn’t have a profitable year until 2003, when its stock price was about $50.
Types of P/E Ratios
Investors can compare the ratios in several ways:
Current, using trailing 12-month (TTM) earnings
This usually refers to the last four quarters of reported earnings For example, if a company’s fiscal year is a regular calendar year Jan. 1 to Dec. 31, and the investor is considering an investment in August, she will add earnings for the third and fourth quarters of last year and the first and second quarters of this year, using this as the P/E denominator.
Future or forecast earnings
This is called the forward P/E ratio. It can be based on a company’s forecast for future quarters or the year, or estimates among securities analysts. Investors study the forward P/E ratio because their investment decisions are forward-looking: earnings for the year ahead can matter more than earnings in the year behind.
A forward P/E that is lower than a trailing P/E suggests that investors and analysts expect a company’s earnings to grow.
Shiller P/E, historical earnings
These also can be used to get a long-term picture of price-earnings valuation. The Shiller P/E ratio is the best known, and is used to evaluate market indexes and sectors, not individual stocks. The Shiller model, devised by Nobel Prize economist Robert Shiller and focused on the S&P 500, divides the index price by the inflation-adjusted average of index earnings for the past 10 years (40 quarters).
Professional investors use the Shiller ratio because it accounts for inflation and because it uses a 10-year period, enough to incorporate a full cycle of the economy—strong-growth and weak-growth years. A shorter time span might catch only one part of the cycle and thus produce a distorted P/E ratio. For this reason the Shiller ratio also is called the Cyclically Adjusted Price-Earnings (CAPE) ratio, because it smooths out the undulations of an economic cycle.
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