Know Limits and How to Use P/E

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One number you will frequently hear as the yard-stick for measuring the value of a stock is the P/E or price earnings ratio.

For many stock market investors, the P/E is the single most important number when considering the valuation of a company’s stock.

As I have said in many previous articles, you should never buy or sell on a single number, however the P/E is the king of ratios.

A quick review: P/E is calculated by dividing the price per share by the earnings per share. You can use historical earnings, current earnings or projected earnings to get different looks — just be sure if you are comparing the results to other companies you use the same period.

What Market will Pay for Stock

The P/E tells you what the market is willing to pay for the company’s earnings.

If a stock has a P/E of 15 that means the market is willing to pay $15 for every $1 of earnings.

For this reason, P/E is sometimes referred to as a multiple. In the above example, the stock has a multiple of 15.

Companies with good growth potential will have a higher P/E because investors are willing to pay a premium for future profits.

The there are three different versions of the P/E ratio is important to know which one is being used in a particular analysis. The difference is how the earnings per share is calculated. You want to make sure that you are comparing two ratios using the same earnings per share formula.

The first and most frequently used is based on earnings per share of the previous four quarters. This is called a trailing EPS and obviously reflects the actual earnings per share.

Another looks forward four quarters and uses estimates of what earnings per share will be in the future. This number also called forward EPS and it is an attempt to estimate how the market will value a stock in the near future. It is only as good as the estimates of the earnings per share for the coming four quarters and that makes it an educated guess at best.

The third way to calculate the P/E ratio is to use a combination of trailing earnings per share and forward earnings per share. Typically this is done by taking two quarters of previous earnings per share and two quarters of the future estimates of earnings per share and averaging these to come up with a number that is still an estimate but is more rooted in a historical reflection than the pure forward EPS.

While the P/E is often used to determine how much the market is willing to pay for earnings is also an estimate of the markets opinion of the firm’s future growth. A high P/E generally means the market believes growth will be strong, while a low P/E does not put much value in future growth prospects.

Like most ratios, the P/E ratio has much more meaning when it is used compared to other companies in the same industry. This is because growth rates in some industries are significantly different than expected growth rates in other industries.

In most cases, a utility would not be expected to grow as fast as a tech company, for example.

High-Risk Stocks

High-risk companies will typically have low P/Es, which means the market is not willing to pay a high price for risk.

Is the P/E system perfect in assigning risk premium to stocks?

Unfortunately, it is not.

The crazy tech market of the late 1990s saw investors putting very high premiums on tech stocks they thought were super-growth companies.

Some of these stocks carried very high P/Es — even though some had never earned a profit — because investors thought the stock would skyrocket.

Stocks Collapsed

Many of the stocks did shoot up, but almost all of them came crashing down with disastrous consequences.

For all its faults, P/E remains one of the best ways to judge a stock’s value. You can compare companies in the same industry and look at historical trends.

Don’t make a buy or sell decision strictly on P/E, but it can be a good indicator that a stock is worth studying some more — or not.