Education: Value Investing

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How to Use the Price-to-Earnings Ratio

If there is one number that investors and analysts look at more than any other, it is most likely the price-to-earnings ratio, or the P/E ratio. While the P/E ratio is one of the oldest and most frequently used measures, it can also be one of the most misinterpreted and misused.

Price-to-Earnings Ratio Defined

The P/E ratio measures the relationship between a stock’s price and its earnings, or profits, per share. The ratio is calculated as follows:

P/E = Price per Share/Earnings per Share (EPS)

Let’s look at a simple P/E calculation example. Play Now Corporation’s (a fictitious company) stock is currently trading at $35 per share. Last year, the company posted earnings of $1.25 per share. What Play Now’s P/E ratio?

If you answered 28, you are correct. Notice that the example used Play Now’s EPS from the past year. This is referred to as a trailing P/E. Projected P/E ratios can also be calculated in which estimates of the company’s future earnings are used. Thus, one uses purely historical data while the other utilizes analysts’ best guesses. More on this a bit later in the article.

Okay, if you were able to calculate Play Now’s P/E that was the easy part. But how do you interpret it? Or any company’s P/E ratio for that matter?

Digging a Little Deeper

The P/E ratio gives investors an idea of what the market is willing to pay for a company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. And yes, you guessed it, the lower the P/E the less the market is willing to pay for a company’s earnings. Play Now’s P/E ratio of 28 means that investors are willing to pay $28 for each $1 of earnings that the company generates.

Taking this a step further, some investors interpret a “high P/E” as an overpriced stock. Conversely, the market may be very optimistic about the company’s future and has bid up the stock price—leading to a “high P/E.”

A company with a “low P/E” may be overlooked or ignored by the market. Value investors are constantly on the hunt for these sleepers, jump in and purchase, and ride the stock’s price upwards as the market comes to realize its true value. Or, perhaps the market has driven the stock price down because the company is currently exhibiting poor fundamentals.

Which is the case???

Fruitful Comparisons Needed

Play Now participates in the sporting goods industry. Comparing its P/E to the P/E of a company that participates in, let’s say, the restaurant industry, just doesn’t make much sense. It would be the equivalent of comparing apples to oranges.

P/E's need to be placed in a context that gives them meaning. You want to compare Play Now’s P/E to that of another participant in the sporting goods industry. Or, you can compare it to the industry average. Taking a look at the companies below, which company would you allocate your investment dollars towards? Play Now or Competitor’s Edge?

Play Now

Price: $35

EPS: $1.25

P/E Ratio: 28

Competitor’s Edge

Price: $20

EPS: $1.25

P/E Ratio: 16

If you answered Competitor’s Edge, that is not necessarily the correct answer. At first glance it makes complete sense. Both companies have the same earnings per share but Competitor’s Edge is selling for quite less.

But let’s revisit the EPS component of the calculated P/Es. Historical data was used for Play Now and for Competitor’s Edge as well. And as we all know, historical performance is not indicative of future performance. As was mentioned earlier, you need to make certain you know what type of earnings is being used in the P/E ratio calculation. Historical or projected?

While trailing P/Es are not very helpful when making investment decisions, forward P/Es are a step in the right direction. For an even better ratio, you should consider the PEG ratio. Learn more about the PEG ratio.

Earnings Estimate Revisions and the Zacks Rank

The P/E ratio should never be used as the end all be all when trying to determine whether a company is currently undervalued. It doesn’t matter if it is a trailing or a forward P/E. No ratio should be used in isolation for that matter.

In the earlier example, most would be led to believe that Competitor’s Edge is the better choice. In order to help with the decision-making process, one needs to examine whether the company’s earnings are being revised upwards or downwards.

Earnings estimate revisions have a tremendous impact on stock prices and serve as the single best gauge of the future prospects of a company. And the best way to harness this phenomenon is through the Zacks Rank. (Learn more about the Zacks Rank). If Competitive Edge has been receiving positive earnings estimate revisions leading to a better Zacks Rank when compared to Play Now, Competitive Edge looks to be the better choice after all.