The P/E Ratio Part 4

This is the last part in the series giving a basic description of The P/E Ratio. You can read Part 1, Part 2, and Part 3 by clicking on the appropriate links.

Putting It All Together

The first three parts in this series basically explained that the P/E ratio is a way to guage what investors are willing to pay for the future income stream of a company, and how much of a discount they wish to receive in exchange for accepting the risk associated with that income stream.

But the P/E ratio is far from an exact science – it is more of a black art. How accurate are analysts’ predictions about earnings two years from now, let alone 80 years from now like in our example? Think of it like throwing darts except replace “year” with “feet from the dartboard”. Predicting earnings for 1 year (throwing a dart from 1 foot) is much easier than predicting earnings 20 years from now (like throwing a dart when standing 20 feet away). There are just too many things that can happen to change the future fortunes of a company.

So how do people use the P/E ratio?

The P/E Ratio, like many other stock analysis tools and metrics should be used as part of your analysis, not as the basis of your analysis. I would use it to raise flags, not to screen investments. People generally look at a P/E ratio and compare it to the P/E ratio of something relevant. That ‘relevant thing’ could be the historical average P/E of the stock in question or the average P/E of all the similar companies in the same industry.

If the stock’s current P/E ratio is much higher than it’s average, this might be referred to as being “expensive”. It might also mean that the company is expected to grow it’s earning faster than it has previously. The fact that the P/E is higher than it’s average means nothing in and of itself.

Conversely, if the stock’s P/E ratio is much lower thant it’s historical average, this might be referred to as being “cheap”. It might also mean that the company is expected to have lower earnings than previously thought. Many value-investors would look at a low P/E ratio as a good thing if they believe nothing has changed with the company since they would consider a value stock as a company that is temporarily undervalued for no good reason (which a lower than average P/E ratio might suggest). The classic value trap is when the P/E ratio is low, making the stock look cheap, and value investors pounce only to find out that something is indeed wrong with the company and the earnings decline and the stock price follows.

Comparing Relative P/E Ratios

Where knowing the P/E ratio can be of more use is when comparing the P/E ratio of a company against it’s competitors with similar characteristics, the market as a whole, or as mentioned above, against it’s historical average.

Different companies in different industries may have higher or lower P/E ratios based on what kind of company they are. For example, the big blue chip stocks (like a utility company) might have a low normal range of P/E ratios because they are more mature and are not expanding anymore – their earnings may not be growing as fast as a high-tech company that arrives out of nowhere and expands and grows furiously. However, a high-tech company with a P/E ratio of 30 might be cheap, whereas a bank with a P/E of 20 might be expensive – it’s all relative.

The Market P/E Ratio

The market P/E ratio is simply the total market capitalization of all stocks in the market divided by the total earnings of all the companies in the market. Some people use the market P/E to make decisions about whether the market as a whole is “cheap”, “expensive” or around it’s long term average. They may choose to avoid picking any stocks if the market is expensive because sometimes the baby gets thrown out with the bathwater (meaning that during market declines, sometimes it doesn’t matter what you own, it might be going down too).

That’s All For Now

I’ll end there. This was supposed to be just a basic primer on the P/E but I ended up getting possessed and turning it into a four-parter! If you want to learn more about P/E ratios, a simple google search will yield lots of great material.