How to use a price-earnings ratio for investing

This ratio is a tool used by investors and analysts to determine a stock's valuation.

  • By Barbara Friedberg,
  • U.S. News & World Report
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Investors often look at earnings to determine whether a stock or a fund will increase in value.

Since stocks are riskier than cash and bonds, investors expect higher returns from equities. The price-earnings ratio, widely considered the price tag of the stock market, is a savvy metric to uncover undervalued stocks and those expecting rapid growth.

Here are a few answers to several common questions about using a price-earnings ratio when it comes to stock and fund selection:

  • What is a P/E ratio?
  • How do you interpret a P/E ratio?
  • What are the limitations of the P/E ratio?

What is a P/E ratio?

The P/E ratio tells an investor how much a buyer is willing to pay for $1 of a company’s earnings.

“When it comes to valuation ratios, the P/E ratio is most prominent because it is used as a benchmark to tell them if a stock is relatively cheap or expensive," says Robert Johnson, professor of finance at Creighton University's Heider College of Business.

For instance, a stock with a low P/E ratio may indicate the company is undervalued, and the investor could stand to profit as the share price climbs. Conversely, a high P/E ratio may suggest a stock is overvalued.

But the P/E ratio formula is more complicated than meets the eye. There are various ways to calculate the ratio along with distinct interpretations.

The simplest approach to calculate a P/E ratio is to take the current share price, widely available online, and divide that number by the company’s earnings per share, commonly referred to as EPS.

But that’s when the P/E calculation gets tricky, as there are various EPS numbers to use in the denominator.

The traditional P/E calculation divides the current stock price by the company’s trailing 12 months earnings. For example, if a stock is selling for $50 a share and the prior 12 months earnings per share was $2, then the P/E ratio would be 25.

Many analysts prefer the forward P/E ratio that compares the current price with expected earnings for the upcoming year. With a growing company, forward earnings are typically higher than trailing earnings and the P/E will be lower.

The same $50 stock with next year's earnings predicted at $2.50 would have a forward P/E ratio of 20. The lower ratio suggests that the stock is more reasonably priced than a higher P/E ratio of 25, calculated with the prior year’s earnings. The same stock can have different P/E ratios depending on how the number was calculated.

P/E is also computed for the total stock market by dividing the average stock price of the S&P 500 (.SPX) with the average EPS.

The Shiller P/E – known as the cyclically-adjusted price-to-earnings, or CAPE ratio – divides the current price by the average earnings of the past ten years. This metric is typically applied to the S&P 500, but it can be used for other indexes and individual stocks.

Knowing how to calculate a P/E ratio is worthless if analysts and investors can’t interpret the ratio. The P/E ratio is used by value investors, momentum investors and others to assist with their investing decisions.

Before delving into analysis, it’s useful to grasp that there’s rarely a good or bad ratio: The number should always be used in conjunction with a complete individual stock or market analysis.

How do you interpret a P/E ratio?

Now the fun begins. Analysts use the P/E ratio in multiple ways.

“All other things being equal, a company with a high P/E ratio is expected by the market to grow more quickly than a company with a low P/E ratio,” says John Riddle, chief investment officer at 361 Capital in Denver.

Momentum or growth investors, those who believe that a rising stock price will continue, are more likely to accept a stock with a higher P/E ratio, as an indicator of rapid future growth. These investors believe that high expected future growth justifies purchasing a richly valued company, he says.

Stocks with higher P/E ratios can be found in rapidly growing industries, such as technology. In contrast, value investors hunt for companies with lower P/E ratios, with shares selling below value.

Lower P/E ratios can also be an indication of a slow-growing company, a company with major problems, or a relatively sluggish industry.

“A low P/E can indicate that a stock is a bargain if the firm has strong fundamentals (such as profitability). But a low P/E can also indicate that the firm is appropriately valued due to poor future prospects,” Johnson says.

P/E ratios are also useful in guiding asset allocation decisions.

Adjusted P/E ratios, such as the Shiller P/E, have exhibited a strong correlation to future stock market returns. In fact, a CAPE ratio "does a better job of forecasting risk-adjusted returns than it does absolute returns,” says Robert Drach, founder of Drach Advisors in Tallahassee, Florida.

For instance, a higher CAPE ratio, in comparison with its average, has foretold lower future stock market returns. This information might recommend trimming portfolio allocations when this ratio is significantly above the average. In early March 2019, the Shiller P/E was about 30, nearly double the average of around 16.

But before acting on the highly valued P/E ratio, be cautious of using the CAPE ratio as a short-term timing tool. Stock markets can remain overvalued for long periods of time, making market timing a risky business.

What are the limitations of the P/E ratio?

Despite the analytical strength of the P/E ratio, this number has its limits.

“When you're at the top of the economic cycle and profits are booming, a stock can seem artificially cheap, as the denominator – the 'E,' or earnings – is inflated. At the same time, near the bottom of the economic cycle, when profits are depressed, a cyclical stock can look expensive in P/E ratio terms because the denominator is temporarily depressed,” says Charles Sizemore, portfolio manager at Interactive Brokers Asset Management.

Those limitations underscore the benefits of using the Shiller ratio with a longer term earnings period. That smooths out the earnings number.

Additionally, it’s difficult to use the P/E for comparison across industries, as the metric can be industry specific. Software stocks usually have higher P/E ratios than slow-growing utility companies. So it’s best to compare P/E ratios within industries, Sizemore says.

Finally, it’s widely accepted that earnings can be manipulated. When that occurs, the P/E ratio may be less reliable.

Ultimately, the P/E ratio is a solid place to start an investment analysis for a quick valuation check of a market or stock. For best practices, add the P/E ratio to a more complete analysis of individual companies, industries and the economy.

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