Understanding the PE Ratio
Most investors are best suited to invest in a diversified portfolio of index funds in an asset allocation in line with their risk tolerance. The research is quite clear that it is exceedingly difficult to beat the overall stock market over time. That said, there are those who like to analyze individual stocks and attempt to beat the market. For those active investors, as well as those interested in understanding a bit more about investing, you’ll learn about how to use the PE ratio when investing. Read on to find out the answer to the questions:
- What does price earnings ratio mean?
- What does a high pe ratio mean?
- Should I invest in low pe ratio stocks?
Prognosticators predict the future direction of the stock markets. There is no proof that over time anyone has consistently done a good job at this forecasting. In most cases correct predictions could just as easily be attributed to luck and skill. The main problem with forecasting the overall stock market is this; although one might be able to correctly pinpoint an overvalued stock market, in comparison with historical norms, there is no way to determine how long that overvalued market might continue to remain overvalued. Or, if that said market might become even more overvalued.
“Markets can remain overvalued longer than you can stay solvent.” John Maynard Keynes
In spite of the difficulty in predicting the future direction of the stock market, the PE ratio is a useful tool to use as a guide to relative valuation of both individual stocks and markets in general.
In fact, I’ve made it a habit to save cash when PE values are high so that I can invest an extra amount after a stock market drop, and PE ratios are low. This strategy has led to profitable long term returns.
How to Calculate a Price Earnings Ratio
As I taught in my university Investments class, the price earnings ratio, or PE ratio is a method to value an individual stock or an aggregate stock market. There are several ways to calculate this ratio.
The most popular is to take the current price and divide it by last year’s earnings. For example, if a stock, ABC, is selling for $20.00 per share and last year’s earnings were $.75 per share, then the PE would be 20/.75 or 26.7. The 26.7 means investors are willing to pay $26.70 for each $1.00 of earnings of ABC stock.
Robert Shiller reports another take on the PE ratio-the CAPE PE ratio or PE 10:
“Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10”
The CAPE PE averages out the price to average earnings from the past ten years. That way, the ratio is smoother, more conservative and less apt to wild highs and lows.
The CAPE PE is calculated by:
- “Look at the yearly earning of the S&P 500 for each of the past ten years.
- Adjust these earnings for inflation, using the CPI (ie: quote each earnings figure in 2017 dollars)
- Average these values (ie: add them up and divide by ten), giving us e10.
- Then take the current Price of the S&P 500 and divide by e10.”
Regardless of which PE ratio you use, just be consistent and use the same one when analyzing a stock or market.
What Does Price Earnings Ratio Mean?
A high-er PE ratio suggests investors expect higher growth from the company. But that still doesn’t explain when a stock or market PE value is at a reasonable level.
- Is 26.7 a good or bad PE? Is a stock with a PE ratio of 26.7 over or undervalued?
- Should I continue considering a stock for purchase with a PE ratio of 26.7?
Unlike buying a pair of shoes where $35.00 is cheap and $175.00 is expensive, understanding a PE ratio is not so easy.
1. Specific industries have certain PE ratio ranges. For example it might be normal for a slow growing utility company to have a PE ratio between 6 and 10. Whereas a fast growing technology company might typically have a PE ratio in the range of 14 to 26.
2. Individual companies also have ranges in which their stock usually trades. If ABC Company had a PE ratio between 16 and 28 during the past five years. And today ABC’s PE ratio is 27, you might assume that the company is over valued.
3. Evaluate a company’s PE ratio in comparison with its own five year average and that of its industry. If it’s current PE ratio is on the low end of it’s historical range, it might be a buy. If it’s on the high end, then it could be overvalued.
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What Should an Investor do When a Stock or Market PE is Near a Peak?
If you were researching the stock for potential purchase, it’s a good idea to look for a company whose relative PE is lower. Research has shown that over the long run, high PE stocks offer lower future returns than lower PE stocks. Yet, in the short term anything can happen.
Even high PE markets and companies can stay richly valued for a long time. In 2015, I wrote “When Will the Stock Market Crash?” and they markets are still rising today!
In summary, a quick PE study is an efficient way to get a ball park valuation of a stock. If you’re looking for stock candidates for potential purchase, check out the company and industry’s historical PE’s to determine whether you want to research further, or move on to the next one.
Remember, lower PE ratio stocks and markets correspond with higher future returns.
Have you ever done a PE ratio analysis?
A version of this article was previously published.