Investing

Understanding this ratio can help you 'comparison shop' as an investor

Price-to-earnings ratios help you understand whether stocks are bargain-priced or overvalued.

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If you're shopping for anything, be it groceries or a new house, it pays to compare prices and weigh your options. You don't just buy the best item, or the cheapest one. Rather, you decide based on the information available to you which purchase is going to offer the best bang for your buck.

The process for deciding which stock to buy is no different, says Sam Stovall, managing director of U.S. equity strategy at investment research firm CFRA. "Just as you comparison shop for a variety of consumer goods, you need to do the same with stocks," he says. And "just because you like a company doesn't mean it's attractively valued."

Among the many parameters investors use to determine the value of a stock, the price-to-earnings (P/E) ratio is ubiquitous — a tool favored by financial pros and do-it-yourself investors alike. Knowing this one number alone (also called a stock's "multiple") won't tell you whether a stock is going to be a world-beater or a dud, but understanding this metric can help you put investment data in context and make you a more discerning buyer of stocks.

How P/E ratios work

A stock's P/E ratio is calculated by dividing its share price by its earnings per share. In general, stocks with low multiples are considered cheap or a good bargain, while companies with sky-high P/Es are considered overpriced.

Done and done, right?

Well, no. As with everything in the world of finance, there are several complicating factors. For one thing, there are two main flavors of P/E ratios. One is "trailing" P/E, which compares a stock's price to its reporting earnings over the previous 12 months. You may see this noted on financial websites as "TTM" for "trailing twelve months."

The other is "forward" P/E, which divides the stock price by projected future earnings, commonly over the next 12 months.

For an investor assessing an individual stock, it pays to assess both, says David Sekera, chief U.S. market strategist at Morningstar. "Looking at one P/E number only provides a limited, point-in-time metric for valuation," he says. "It doesn't address potential earnings growth. Ideally, you'd look at multiple ratios, and with growing earnings, you see how quickly that future ratio would be coming down."

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That partially explains why a stock with a high P/E isn't an inherently worse deal than a stock with a low multiple. As an investor, the price you pay for a stock today reflects expectations for future earnings growth, which will theoretically increase the value of your shares, either through dividend payments or because the stock price appreciates, or both.

Investors, then, should be willing to pay a premium for companies they think will boost earnings at a fast rate and less for firms that are slow-and-steady growers.

Think of it like pricing real estate, suggests Stovall. "Just like you're willing to pay a higher price per square foot for a house with a waterfront view, you should be willing to pay a higher P/E for a company with high growth potential."

Comparing apples to apples

The P/E ratio is a widely used stock metric because it can give investors a read on an investment's relative price. And because every publicly traded company reports earnings, you can be assured that you're getting an apples-to-apples comparison.

"You can use other P/Es to get an idea of what the norm is," says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. "Then you can judge if it's lower than normal or if you're paying a premium."

By comparing a company's P/E with that of a broad stock market index, such as the S&P 500, you can get a sense of how its valuation compares to that of the overall market. To further bring things into focus, compare how a stock's multiple stacks up with the average for stocks in its sector. "A slow moving, dividend-paying, regulated utility is only going to grow so much," says Silverblatt. "You expect a lower P/E than you would with an IT company, because it won't be growing as much."

Just like you're willing to pay a higher price per square foot for a house with a waterfront view, you should be willing to pay a higher P/E for a company with high growth potential.
Sam Stovall
managing director of U.S. equity strategy, CFRA

Take Microsoft, which currently trades at 31 times its projected earnings for the next 12 months. That's more expensive than average forward P/E ratio of 23 for the S&P 500, but the stock isn't trading very far out of line with the average large technology company, which trades for 27 times earnings.

Pay attention to a company's historical P/E ratios as well, says Stovall. A company that trades at a premium to peers could nevertheless represent a bargain if it trades well under its historical valuation.

Use P/E to take the market's temperature

Investors also use P/E as a kind of market thermometer. Earnings projections for stocks are calculated from an aggregate of forecasts from Wall Street analysts who themselves take cues from the companies' own estimates. The price investors are willing to pay for those future earnings reflects the market's confidence in the direction stocks are headed, says Stovall.

"The S&P 500's current P/E ratio of 23 for the next 12 months is saying two things," he says. "First, it assumes the 12-month outlook for stocks is correct, and that we'll get a more than 20% earnings growth rate. And then, when you compare it to the index's 20-year average of 16.7, you pretty much have to say, gulp, that's a 40% premium to its long-term average."

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In other words, stocks are very expensive right now on the expectation among analysts that corporate earnings will bounce back drastically in 2021. That assumption, says Silverblatt, is based on the theory that a treatment for the pandemic will bring the economy back to life faster than the spread of the disease can continue to wreak havoc. "If the treatment doesn't work or we have another big setback, that's when you could get a very big decline," he says.

Which isn't to say that a high overall P/E is a sign you should panic or make big changes to your portfolio, says Stovall. "I just wouldn't assume that the market is a tremendous bargain and that you should be backing up the truck to buy shares in the overall market."

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