Tips for Value Investors - #2: Understand the Price-Earnings Ratio

The P/E Ratio of a stock is simply its current share price divided by the company's earnings per share for the previous twelve months.

(P/E Ratio) = (Stock Price) / (Earnings Per Share)

For example, Stock A is trading at $48 per share, and reported $2 earnings per share for the trailing twelve months, i.e. the most recent twelve months. We then calculate Stock A's P/E ratio at 24.

Great... So what does this mean, exactly?

To help explain why this is a fundamentally important concept for value investors, let's look at two similar stocks in the same industry. We'll call them Stock A and Stock B.

Example 1: Assume that Stock A and Stock B are identical in all areas: financial health, dividend yield, current ratio, revenue growth, etc. Except that, Stock A has a Price-Earnings Ratio of double that of Stock B. Now take another look at the formula above. If Stock A's P/E is double Stock B, what does that tell us? Well, it tells us that one of two things (or a combination of both) must be true: either Stock A is trading at a higher price than Stock B, or its earnings per share is less than Stock B's.

Think about that for a minute. If, as we have already said, the two companies are nearly identical, why should we be willing to pay more for Stock A returning a lower earnings per share?

What makes the P/E Ratio so useful is that it allows the investor to take two similar companies in the same industry and compare their prices on even terms.

Here is another example:

Example 2: Assume the same facts as in example 1 above, except that now we know that Stock A is currently trading at $50 per share and reported earnings per share of $2 per share in the trailing twelve. And we also know that Stock B is trading at $24 and reported earnings per share of $0.50.

The novice investor might look at the two similar companies and suppose that Stock B trading at $24 is the better deal. However, if we compare the two stocks' P/E Ratio, we find that Stock A has a P/E of 25 ($50 price / $2 EPS) and Stock B has a P/E of 48 ($24 price / $0.50 EPS). Knowing this, we must reevaluate the situation and consider that Stock A may in fact be the better bargain, even though it is trading at a higher price.

Of course in the real world, we don't find identical companies so the P/E Ratio cannot provide us with the be-all end-all measurement for stock value. But here are a few take-aways when you're looking at P/E Ratios:

1. Always compare a company's P/E Ratio with the average for other companies in its industry.
2. Look at the company's most recent earnings and consider whether any abnormal fluctuations in earnings may have skewed the P/E Ratio. For example, if a company reported profits for the trailing twelve months of far greater than it averaged over the last five years, you have to ask yourself whether the P/E may be artificially deflated as a result, making the stock look more attractive than it actually is.
3. A great way to screen stocks for value is to look at the P/E Ratio along with the Price to Book Ratio and Price to Sales Ratio. I will add posts on these soon, here.
4. With all this said, my last piece of advice is that you not place too much emphasis on the P/E. You may hear other investors quote rules of thumb like "anything above 20 P/E is overpriced." Forget that. Just remember that no one indicator is the most import. Value investing and stock analysis is a big-picture process. Don't get yourself bogged down in the details.

Happy investing!

What do you think about the P/E Ratio? Is there anything I missed or got wrong, in your opinion? Let me know in the comments.