Make Smarter Investments by Mastering This Simple Ratio

By Damian Davila on 11 April 2017 0 comments

When doing your research on what stocks to invest in, you will undoubtedly hear analysts and financial pundits mention something called a P/E, or price-to-earnings, ratio. This is one of the key numbers in a stock table, and one you'd be wise to brush up on. Let's review what the P/E ratio shows, how investors use it to evaluate a stock, and some guidelines to make the most of it. (See also: Beginner's Guide to Reading a Stock Table)

What is the P/E ratio?

It's the ratio of a stock's market value per share to its earnings per share (EPS). Generally, the EPS is from the last trailing 12 months (TTM). However, some financial analysts may use an EPS figure from a shorter trailing period, such as one or two quarters, or a future period, such as over the next six to 12 months.

This is why it's important to pay attention to whether a P/E ratio calculation is using historical or projected numbers. Estimated numbers are subject to a margin of error and will be updated as new data becomes available.

A P/E ratio tells you how much investors are willing to pay to receive $1 in return for investing in a stock. Historical data suggests that on average, investors are willing to pay $15 for every dollar of earnings (a P/E ratio of 15). However, P/E ratios can vary across industries and particular companies. On March 10, 2017, the P/E ratios of Facebook Inc. [Nasdaq: FB], McDonald's Corporation [NYSE: MCD], and Toyota Motor Corp. [NYSE: TM] were 39.95, 23.36, and 10.70, respectively.

How investors interpret the P/E ratio

The main appeal of the price-to-earnings ratio is that it provides a single, standardized metric to an investor evaluating whether or not a stock is worth buying (or selling).

However, any P/E ratio is open to a lot of interpretation.

High P/E ratio

On one hand, a high P/E ratio could indicate that investors are expecting a company to grow its future earnings. On the other, it could be a signal of "irrational exuberance" — a term coined by former Fed chairman Alan Greenspan to refer to unsustainable investor enthusiasm. (See also: 3 Pearls of Financial Wisdom From Alan Greenspan)

With a P/E ratio of 331.23 (no, that's not a typo!) as of March 10, 2017, Netflix, Inc. [Nasdaq: NFLX] is open to both interpretations. One investor could argue that the future of media is online streaming and that this company is making all the right moves to become a leader in this industry. Another could argue that this market valuation is a bit out of whack.

Low P/E ratio

While one investor may think that a low P/E ratio indicates that a stock has seen better days, another investor may interpret that same low P/E ratio as a chance to snap up some shares at a low price.

Shares of Apple Inc. [Nasdaq: AAPL] provide a great example of this scenario. With a P/E ratio of 16.66 as of March 10, 2017, some investors may think the performance of Apple is just slightly above average (remember the long-term average of 15). Other investors may think that this is just a slow period and that it has room for growth since its maximum P/E ratio for the last five years is 18.51.

How to make the most out of the P/E ratio

Now that you know what it is, let's turn to putting it to work.

1. Don't rely solely on the P/E ratio

Due to the math behind the P/E ratio, publicly traded companies that are losing money don't have a P/E ratio at all! For example, the hottest talk of the investing world right now, Snap Inc. [NYSE: SNAP], doesn't have one. So for now, their P/E ratio is irrelevant, and you should rely on an alternative valuation metric, such as the price-to-sales ratio.

2. Put the P/E ratio in perspective

It's a smart practice to measure a stock against a group of comparable peers. For example, you could compare the P/E ratio of Marriott International Inc. [Nasdaq: MAR] against that of Hyatt Hotels Corporation [NYSE: H], Wyndham Worldwide Corporation [NYSE: WYN], or the average of the ones from several others within the same industry.

Another way to put that P/E ratio into context is to use its historical average, maximum, and minimum. By taking a look at these numbers and evaluating the decisions from management, you can have a better understanding of the current ratio.

3. Pay attention to the P/E ratio with buy recommendations

If you receive recommendations from your friends, relatives, or favorite TV pundits that you should buy a particular stock because it's "going places," pay attention to the P/E ratio. If a stock price rally is a rocket, the P/E ratio is the fuel that helps it take off … and keep rising. Without a high enough P/E ratio, a rally will be short-lived or, even worse, turn the other way around.

4. Beware accounting shenanigans

Companies with one-time events, such as selling off a major division or cutting down employee benefits, can alter their earnings and, as a result, their P/E ratios. Dramatic ups and downs in the P/E ratio would render this ratio useless and you'll have to use an alternative stock valuation metric.

This is why it's a good idea to keep an eye on current (also known as trailing) and forward P/E ratios. A big difference between these two P/E ratios is a sign that there was a one-time event. Analysts suggest that when there are too many instances of these gaps, investors should pay closer attention to the cash flow statement on company filings.

P/E ratio is no silver bullet

While the P/E ratio can be a useful metric to select stocks, it's no silver bullet. This is why it's important to continuously educate yourself about the inner workings of the stock market and seek the advice of a financial adviser whenever appropriate. (See also: Who to Hire: A Financial Planner or a Financial Adviser?)

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