Price to Earnings Ratio

One of the best indicators of the worthiness of a share of stock is the Price to Earnings Ratio or P/E. This is simply:

Price per share / Earnings per share = P/E

The price to earnings ratio can give us information about how over or under-priced a stock is, and hence what it might do in the future. Suppose a hypothetical stock was $25 a share. And suppose that the company had earnings of $2.27 per share. Then the P/E would be:

25 / 2.27 = 11.01

Generally speaking, a moderate price to earnings ratio is desirable. Why is this important? A high P/E means that the price of a stock has been driven up by speculation. In particular people may be anticipating future earnings of the company. If the price to earnings ratio is high relative to the overall stock market and as compared to other companies in its industry, that means a large fraction of the price of the stock depends on increasing profits in the future. The more you’re speculating on increasing profits on the future, the riskier ground you’re on.

A moderate P/E is around 15 while a P/E below 15 is even better (that’s an underpriced stock). When talking about picking stocks, Intelligent Investor author Graham says:

“Current price should not be more than 15 times average earnings the past 3 years”.

In Discover The Wealth Within You by Ric Edelman, he mentions that the average P/E for the overall stock market is in the 15 to 18 range. That’s a good benchmark when using price to earnings ratio. When above 18, you should do more research. If its below 15, the stock is a good buy.

Edelman gives some past examples of trouble. In the 1987 stock market crash, the average had bubbled all the way up to 27-an indicator of trouble. Sure enough a correction came along to fix it.

Things can get much worse. During the internet hysteria of the 1990s, America Online stock had a P/E of 453, which is downright ridiculous. That tells you that the price of the stock is way overpriced and the company isn’t bringing in any earnings. People were buying and pushing up the price of the stock simply on the belief that the price would continue to go higher (and they could sell at a profit) combined with the manic belief that AOL would turn a huge profit, someday in the distant future!

Let's look at the P/E ratios of some desirable stocks.

• IBM : 13.31• Apple : 30.95• Google : 38.09• Garmin : 10.48

Well, Apple and Google have very high P/E ratios. We’ll look into this further, but that indicates the stocks are overpriced. IBM shows that price per share is not the whole story. IBM has a P/E ratio of 13.31, which is less than 15 so this is a good P/E ratio. This indicates that IBM is healthy (bringing in good earnings) and the stock is a bit of a bargain, even though its about $130 per share.

Garmin is an even better bargain-the price of the stock is lower in absolute terms compared to the other stocks we’ve looked at, and the P/E ratio is 10.48 which is well below the 15-18 average range. Garmin is looking good for a price increase in the future.

Most investors rely on P/E ratio to determine whether a given stock is a good buy, but there are many other indicators of the financial health of company. A defensive investor will look primarily at P/E ratio (is it 18 or lower, for example) and then consider quantities that will measure the financial health of the company like how much money is coming in, how is it performing relative to last year, how much debt does the company have and so forth.

Of course you can’t look at those things in a vacuum or in absolute terms-a larger context is required. Consider a hypothetical example on a personal level. Maybe an inventor temporarily goes into debt developing a great idea. He may be unemployed and have $50,000 in credit card debt. If you looked at his financial health based on his current income and debt level, you might write him off if you didn’t also consider his new patent that could make him $2 million the next year and completely turn his situation around.

Its like that with companies too- a company may have poor cash flow now, or may be in debt now, or even have trouble making interest obligations when a payment comes due-but you could still want to invest in the company for a variety of reasons. Maybe you believe in the future results of the company-it could be a new company with a brilliant idea, or one in a new industry like genetic engineering that could break out in the future. Maybe a company in poor shape now has brought in a new management team. Or it could be a company like Citibank which is temporarily down due to economic circumstances, but could rebound in the future.

So there are really no hard and fast rules. The only real rule to stick by in picking individual stocks is only invest a fraction of your money in a given stock. Keep up that diversified portfolio, so that if your bets are wrong on a given company you won’t go down with them. If you are a growth investor, price to earnings ratio will need to be considered along with earnings growth. For this you'll be interested in the PEG ratio.

See how Price To Earnings Ratio is calculated at About.com

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