Interpreting PE ratios

Monday 09/08/14

      Last week the S&P 500 index closed higher after the market reacted positively to a disappointing jobs report. Jobs only increased by 142,000 in August but economists were expecting well over 200,000. Also of note, the June jobs report was revised lower by about 30,000. The jobs report is always a very noisy report so it is important not to read too much into one bad report, however after a disappointing start to the year continued weakness in jobs should be concerning. Additionally, the participation continued declining. This week I want to write about something that confuses a lot of people who are new to investing. This newsletter is intended to be a very basic explanation of the price-to-earnings ratio (abbreviated as PE ratio) which is a very basic metric used in value investing.

      If you have ever been confused by a price to earnings ratio don't feel bad even Fed Chairwoman Janet Yellen seemed confused in her recent testimony when she mistakenly referred to it as the "price equity ratio". Most financial websites, such as Yahoo finance or Google finance will allow you to search the price-to-earnings ratio of any stock you want. The price-to-earnings ratio is calculated by dividing the price of a stock by its earnings per-share (abbreviated as EPS). If the company has a high PE ratio it means that either the numerator is large (i.e. has a high stock price) or the denominator is very small (i.e. earnings are low). A company with negative earnings does not have a PE ratio and will usually be displayed as N/A.

      However, you can't stop there because this doesn't tell you the whole story. If a company has a very high PE ratio they may actually just have strong growth that is expected to continue. If the market expects a company to continue growing rapidly it will likely place a much higher PE ratio on it. For example, if a company has a price of $100 and EPS of $2.50 it will have a PE of 40 (100/2.50 = 40) which is about twice the PE ratio of the S&P 500. However, if that company has consistently doubled their earnings every year a PE of 40 might not be so pricy. Assuming that the stock price remains the same and the company doubles its earnings then the PE will drop to a more reasonable PE of 20, and if they were to do that again in the following year their PE would drop to 10. Of course, if a company is growing like this the price will most likely rise over that time period as expectations are fulfilled.

      Typically a PE ratio is calculated by looking at the previous 4 quarters of earnings. However, if you are an investor, you are probably more interested in the next 4 months of earnings. Most financial websites will also publish the forward price-to-earnings ratio. The forward price-to-earnings ratio is the current stock price divided by the expected earnings per-share over the next 4 quarters. Of course, the earnings per-share are not always reliable because a best-selling product may fall out of favor or the company could develop a new best-selling product that causes earnings to be much higher than analysts forecasted. A company that has a forward PE that is less than its current PE means that analysts expect the company to grow earnings, while a company with a forward PE that is greater than the current PE is expected to have lower earnings in the future.

      So how can you use the price-to-earnings ratio to tell if a company is overvalued? One common method is to compare it to similar companies. For example, it wouldn’t make sense to compare Facebook to Ford, because they are totally different companies with different rates of growth. However, it would make sense to compare the PE of Ford to GM or Toyota mature car companies and Facebook could be compared to Twitter or Linkedin. However, a much better way to use PE ratios is to do your own due diligence in the company. If a company has a PE ratio well over 100, has a low growth rate and no clear path to increasing that growth rate, you may want to be wary about making a long term investment in such a company. Oftentimes these stocks may perform extremely well over a short period of time, or even several years, but eventually the market will adjust and the stock will return to a more reasonable valuation. PE ratios can only tell you so much and should not be used as the sole determinant when buying or selling a stock. However, they can sometimes be used as a good starting point for finding good bargains.
Index Closing Price Last Week YTD
SPY (S&P 500 ETF) 201.11 0.07% 8.61%
IWM (Russell 2000 ETF) 116.38 -0.51% 1.04%
QQQ (Nasdaq 100 ETF) 99.89 -0.15% 13.78%

PE Ratio

How to calculate the PE ratio