8 - P/E Ratio
As explained in my last post, the P/E ratio measures the ratio between the share price and the expected earnings per share and is commonly used to determine the relative value of a stock compared to historical values or to other stocks. The P/E ratio is useful for finding which stocks are likely to generate more profit for the investor (lower P/E ratio).
Calculating the P/E ratio is common sense - it is the price of the stock (the market’s valuation) divided by the most recent annual earnings per share. Since the P/E ratio is easy to calculate (unlike intrinsic value, for example), it is popular and gives the investor a sufficient valuation of the stock. The earnings of a stock are important to value it because the profitability of a company and its potential earnings in the future are both abundantly important for the investor.
Additionally, entire market index can also have a P/E ratio - simply the combined P/E ratios of the individual component companies averaged out. The S&P 500, for example, has an average ratio of about 16. Note that the P/E ratio of the S&P 500 is not a completely reliable source of market evaluation.
The P/E ratio is mainly used by investors who want to figure if a stock is overvalued, undervalued, or appropriately priced. To do this, investors compare several P/E ratios of different stocks and use an overall analysis of these comparisons to determine how stocks are priced. A common benchmark for an average P/E ratio is 20 - 25.
Be wary, however, of buying undervalued stocks or selling overvalued stocks. An overvalued stock indicates that investors see growth in this stock. The S&P 500 had a very high P/E ratio of 123 in the spring of 2009. This high P/E ratio would induce people to sell, considering its “poor” earnings, but the spring of 2009 was the start of a long bull market which saw tremendous growth in the valuation of the S&P 500. In general, companies with extraordinary high P/E ratios may be expected to earn big in the future. Similarly, a “low”-priced stock may result in further devaluation because of the large amount of risk involved when buying a cheap stock.
The P/E ratio, while a useful tool, typically requires investors to conduct further analysis before purchasing a stock. The historical earnings per share will not be an accurate means to predict future earnings. Always COMPARE other stocks to the stock you want to buy before buying.