When you invest in a stock, you want to make sure you are buying it at a good price, right? But this isn’t Walmart. You can’t compare the price of Coca-Cola stock to the price of PepsiCo stock and say “this week I’ll buy PepsiCo because it’s cheaper.”
Well, actually, I guess you could decide to buy stocks that way, but it’d be a really bad idea. That’s because stock prices are based on a lot of factors. You aren’t comparing apples to apples when you buy two similar-but-different stocks.
Instead, with stocks you want to figure out the value of each stock on its own. By doing that, you can find out if it is currently undervalued or overvalued. And of course, it’d be better to buy the stock that is undervalued instead of the one that’s overvalued. It’s like finding the blue crab sushi roll at Whole Foods marked (and priced) as a California roll. Not that that’s ever happened to me…
Anyway, the way you figure out the value of stocks is through what’s known as the price-earnings, or P/E ratio.
Why P/E Ratios Are Important
The price-earnings (P/E) ratio is your indicator of whether the stock is trading for a fair price. It may be over- or undervalued. The P/E ratio is a good way, though not the only way, to determine whether you should buy a particular stock.
The price of a stock alone is not an indicator of the stock’s P/E ratio. If Stock A costs $20, and Stock B costs $50, that doesn’t tell you which one is the better deal. For instance, if I told you Coca-Cola was $2 at the store and Pepsi was $5, would you automatically know which one was the better deal? (assume you like Coke and Pepsi equally)
If you are thinking the answer is Coca-Cola, you’d be wrong. Why? Because you don’t have enough information! Now, if I told you a single 20 oz bottle of Coke was $2 and a case of Pepsi was $5, the picture starts to look different. And if I tell you you are actually at the store to buy 100 servings of soda for a party, you can see how knowing the value of something and not just the price is important.
Understanding P/E Ratios
The P/E ratio is the stock price (P) divided by the company’s earnings (E) per share over a certain period of time. It tells you how much you are paying per stock share for every $1 of earnings. For instance, let’s say a company is reporting $20,000,000 (twenty million dollars) in earnings, and there are 20,000,00 (twenty million) shares of that stock. That means the earnings-per-share is $1 (20M divided by 20M is 1).
Now let’s say the stock is selling for $20 each. That makes the P/E ratio 20, because
$20 divided by $1 = 20
High and Low P/E Ratios
On average, the market as a whole has a P/E ratio of about 20 to 25. That means that anything above 25 is considered a high P/E ratio, while anything below 20 is considered low.
When the P/E ratio is high, that means people are paying more per share than the company is earning. This may mean the company is overvalued, but watch out! It could also mean the company is new, when they aren’t earning much yet but have a lot of potential. Or it could simply mean investors expect the earnings will rise in the future.
When the P/E ratio is low, it might be an indication that the company is undervalued. Or, it could have had recent high earnings and the price hasn’t caught up yet.
You might sometimes see a P/E ratio that says “N/A.” This happens if the company either has no earnings (maybe a new stock?) or if the company is reporting earnings losses. Usually P/Es are not reported as a negative, so they display N/A instead.
Types of P/E Ratios
Trailing P/E: a stock’s earnings-per-share is usually calculated from the last four financial quarters (1 year). The P/E ratio is generally not an in-the-moment value, because earnings are announced after the fact. Because of this, most P/E ratios are based off the previous four quarters’ earnings. This is known as a trailing P/E. If it isn’t explicitly stated, assume you are looking at the trailing P/E.
Forward P/E: this is when the P/E ratio is calculated based off the estimated earnings for the next four quarters. It’s also known as a projected P/E.
There is also a ratio that blends trailing and future earnings, but use of that is rare.
Why the P/E Ratio Doesn’t Tell the Full Story about Stock Values
In my example at the top, I compared (notional) Coca-Cola and PepsiCo stocks. Those companies are relatively similar and are in the same sector (groupings by company type). So comparing P/E ratios for Coca-Cola and PepsiCo might be reasonable. But P/E ratio becomes considerably less reliable if you are trying to compare stocks from different sectors. For instance, a technology stock isn’t going to act the same way as a Coca-Cola stock. Technology tends to stagnate then grow by leaps and bounds, while Coca-Cola has been around for a long time and is very stable. So while you can use P/E ratio to compare stocks within a sector, you usually don’t want to cross-compare across sectors.
P/E ratios can also be skewed by leverage (debt). The amount of debt a company has may cause its P/E ratio to be higher, making it seem overvalued. But debt can be an indication that the company is investing in new products or technology, which could cause future earnings to rise.
Finally, and scarily, companies can manipulate their earnings reports. If that happens, the P/E ratio might not be an accurate representation of the company’s value. Remember Enron? That’s an extreme example of a company that did this, misleading their stockholders and causing bankruptcies not only for themselves but for many of their employees.
What To Do With This Information
If you are looking to invest in stocks, you’ll want to at least consider the P/E ratio when you are deciding what to buy. The good news is that the P/E ratio is usually prominently displayed. Look up any stock, and you should see the P/E ratio along with its current price, opening and closing prices that day, dividend yield, and more.
Look at the stock’s P/E ratio, then do a little analysis. Is it much above or below the P/E ratios of other stocks in the sector? If so, why? Did they recently report a large loss, or an abnormally high earnings quarter? Did they take on debt, and if so what do they plan to use the money to do? Is anybody in the financial industry explaining why the ratio is higher or lower than normal?
Once you’ve done that analysis, you can decide whether or not the stock looks like a good deal to you. It’s the same as buying a car, or a house, or a bottle of Coke. The P/E ratio will tell you some of the information you need, but in the end it’s up to you whether that information should lead to a purchase.
Good luck, and happy investing!
Gentle reminder: I am not a personal finance professional. You should always do your own research before making changes to your finances and talk to a professional if you need additional help. Please read my full disclaimer here.
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