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What Is Price-To-Earnings Ratio – PE Ratio?
The most common valuation metric for stocks is the price-to-earnings ratio, otherwise known as the PE ratio. #munKNEE/Money!
- You calculate it by dividing the price of the stock by the yearly earnings per share. For example, a PE multiple of 10 would occur if the stock had a price of $10 and $1 in yearly earnings per share (EPS)…
- In theory, the PE ratio allows you to compare stocks [within the same sector] with each other.
Trailing Versus Forward Price-to-Earnings Ratio
The two types of price-to-earnings multiples are the trailing PE ratio and the forward PE ratio.
- The trailing PE multiple uses the last 12 months of earnings. Those results are established because they have already been reported. However, if the future is expected to be much different than the past, they are useless.
- The forward PE multiple includes earnings-per-share (EPS) expectations for the next 12 months…Because they are estimates, however, they aren’t established like trailing earnings. Estimates can be wildly off due to changes in the economy, increased competition, or poor execution.
The Best Way To Use PE Ratios
Besides comparing stocks to each other, you can compare a firm’s valuation to its historical past. You can look at a firm’s historical trailing and forward earnings ratio to get an idea of whether it is cheap or expensive.
Typically, the media likes to say a stock is cheap if it has a low PE and expensive if it has a high PE. That’s sloppy language in our opinion.
- We think a stock is cheap when it is trading below its intrinsic value
- and expensive when it is above that valuation.
- A ‘value trap’ is when a company that has a low PE multiple isn’t a great stock to own. There technically are no traps to buying value if the value is really there.
What Is A PE Ratio Really?
…The value of earnings is all about the confidence in the business model. This confidence can be affected by competition, regulations, scale, the firm’s balance sheet, and its product pipeline…
How Else To Use PE Ratios?
Besides valuing individual companies, investors also value stock market indexes which are groups of companies investors buy to diversify…The big mistake investors make is ignoring the makeup of the indexes. The entire point of an index is to capture a wide swath of companies, but the companies in the index change over time and the relative weighting varies depending on the country…You can’t directly compare the PE multiple of the S&P 500 with that of MSCI Europe because each index has different sector weightings and its earnings projections are different…
Price-to-Earnings Growth Ratio – PEG Ratio
…Investors take growth into account with the price-to-earnings growth ratio, otherwise known as the PEG ratio, which is the PE ratio divided by growth.
- Usually, high growth companies have higher multiples than low growth companies, but they might have lower PEG ratios because investors aren’t confident in the growth.
- Low growth companies’ multiples are boosted if they pay a dividend because their yield is compared to treasuries. They become bond-like securities.
There’s no rule what the PEG ratio should be. It’s all dependent on how confident you are in the company’s ability to grow.
Conclusion
…The key takeaways from this article are that:
- a stock’s earnings multiple depends on investors’ confidence in the company and its potential.
The fact that you can still make money properly identifying which business has the potential to retain its customers and increase its sales per user or grow its customer base should make you feel more confident in your ability to be a solid investor. It’s not all about who is first to a trade based on news flow.