What is the P/E Ratio?
Investors love their numbers, and not just the prices of their stocks. Any serious investor needs to be comfortable with basic arithmetic, a few ratios, and a little bit of statistics. Some stockpickers take their numbers very seriously, measuring everything from the volume of shares traded to moving averages of prices and more, but all you really need is the right information to give you an edge in the market.
Trendshare tracks several figures from of quarterly and annual financial statements provided to the SEC, but it all comes down to the simplicity of earnings: companies that consistently earn real money are worth owning. This provides tangible measurements that are easy to understand and to correlate with the real-world performance of the companies themselves.
One such measurement is the P/E ratio, also known as the price earning ratio or sometimes the PE ratio.
What is the P/E Ratio
The P/E ratio is the current price of the stock—what it costs to buy one share right now—divided by the yearly earnings of the company per share. It's the amount of earnings you're entitled to for each share of the company you own.
Consider an example. If a company earned a million dollars in 2014 and if there are a million shares of the stock available, the company has earned a dollar per share. If you can buy a share of the company (let's call it Canada's Best Lemonade) for $10 right now, then the math to calculate the P/E ratio is $10 per share in price ÷ $1 per share in earnings. That's a P/E ratio of 10.
Flip that on its side for a moment. At the current price and ratio, for every $10 you spend to buy the stock, you buy the right to $1 in earnings. Don't take that too far, however. Earnings don't translate automatically into a dollar-for-dollar dividend. The company can do a lot with those earnings. It may reinvest them or it may use them to pay taxes or they may be an accounting fiction.
A company with no earnings—or a company which is losing money—has no P/E ratio. Avoid it.
What Does the P/E Ratio Mean?
The P/E ratio means nothing outside of its comparative context. You have to compare it to the company's P/E ratio over time, the P/E ratio of similar companies, and the P/E ratio of the market as a whole.
Historic PE versus Current PE
If Canada's Best Lemonade company has a historic P/E ratio of 15, that means over the lifespan of the company people have been content to spend $15 on a stock which generates $1 per share per year. If the ratio goes up to 20, there's more interest in the stock for some reason—such as more demand pushing up the price. Perhaps earnings are set to go up dramatically or there's another company interested in buying the company or even perhaps earnings have gone down to $0.50 a share for some reason.
If the ratio goes down to 5, the stock price may have gone down on bad news or a major holder has sold a lot of shares and there weren't a lot of buyers or perhaps earnings have jumped and the share price hasn't caught up to it.
Of course, if you paid $1 for a stock way back when and it currently generates $1 in earnings every year right now, pat yourself on the back. You have an effective PE of 1. That doesn't happen often, but if you find an undervalued stock and its price takes off... well, that's a good investment to own.
Comparing Sector/Industry PE to the Current PE
One company in the lemonade business is probably like any other company in the lemonade business. They have more similarities than differences: a critical citrus fruit shortage may drive up supply prices or a national campaign against citric acid in drinks may drive down demand. They all serve a similar market of thirsty people and they all charge relatively similar prices.
When you compare the P/E ratio of one company to that of another company in the same type of business or the same business sector, you'll get a better understanding of how investors evaluate both companies. You still have to look at historical norms and probably read a few news headlines to get a fuller understanding, but you can see how investors feel about each company by comparing this number.
The Industry P/E represents the price to earnings ratio of all companies in that industry. Similarly the Sector P/E represents that ratio of all companies in the sector. This can be enlightening if it illuminates substantial and interesting differences in standout stocks.
Comparing the Market's PE to Current PE
The market as a whole (and the leading market indexes like the Dow, S&P 500, and NASDAQ each have their own P/E ratios. This number is a snapshot of global investor sentiment. When that number's above historic levels, you know that more money is flowing into the market and buying shares or that earnings are going down. Similarly, when that number is down, money may be flowing out of the market or earnings are going up. (You need to figure out which is happening to plan your strategy.)
When you compare the Lemonade Company's P/E ratio to the market or an index P/E ratio, you can see if the company's stock is moving with or against gestalt market sentiment. This will help you ask questions to figure out why. Perhaps the company's investing more money in expansion right now, knowing that it'll hold down earnings now but hoping it'll help them grow faster in the future. Perhaps it has new management that's slowly driving it out of business. You can get hints by digging around in the news.
What is a Good P/E Ratio?
You can't just look at this figure in isolation; you can't say that a company with a PE ratio of 4 is a better deal than a company with a PE of 20. Sometimes a company like Amazon.com is still a valuable stock to hold, if you can buy it at a good price, because it makes boatloads of money even though it always reinvests those earnings and never reports them as earnings. Similarly a company that had great earnings one quarter and has been cratering since then may have a stock price that's slowly sinking in value as investors realize it's not worth owning. Then again, a lot of stocks with sky high ratios aren't worth buying at the current price.
Furthermore, as Fool.com points out, the change of PE over time is a good measurement of investor sentiment and financial conditions of the company. It's a marker, but it depends on multiple factors that you can figure out.
A great stock at a good price probably has a favorable P/E ratio, but you'll have to do some research and look at a few other numbers to see if it's really a bargain. (As well, keep in mind that the price you paid when you bought a stock is fixed, and your own personal PE ratio will change as the earnings of the stock change.)