The P/E Ratio Explained For New Value Investors
Seeking Alpha Analyst Since 2020
Summary
- The P/E ratio is simply defined as the Price divided by the Earnings of a stock.
- A lower P/E ratio is generally a good thing.
- Low or rock bottom P/E ratios could indicate value traps.
- A good P/E for a company depends on the growth rate.
So you want to be a value investor? Welcome aboard. You're in good company. The price to earnings ratio is one of those simple things that every investor will use and must understand well. But not so fast, there are some things that complicate the matter. That's why I wrote this article, and I will be writing more in the future to help new and intermediate value investors. You can also read this article and others on my blog www.valueinvesting.today.
THE PRICE TO EARNINGS RATIO
The price to earnings ratio explained… What is a P/E Ratio? What is a good P/E Ratio for a company? And some things to avoid…
The textbook definition of a P/E ratio is the price of a stock divided by the earnings of that stock. The earnings of a stock, the earnings per share (or EPS for short), is simply the net income of the company over the past 12 months divided all the shares outstanding. (For a quick overview of total shares outstanding and EPS, stay tuned for a future article.) In short, P is the price for a slice of a company and E is the earnings that the slice was able to produce.
Here is a simple price to earnings formula.
What is a Good P/E Ratio?
Generally speaking, a lower P/E ratio is good. If an investor was considering an investment between two identical companies with the same earnings, the investor would be wise to choose the one with the lower P/E ratio. This is because he gets more “bang for his buck.” Of course, no two companies are identical, so there are other factors an investor should consider when using a P/E multiple. Some of the factors that should be considered include growth rates, risks, and uncertainties.
Value Trap
While looking for bargains it’s very possible to purchase a stock with a low P/E ratio and still lose a lot of money. The fact of the matter is, some stocks have a relatively low share price for a good reason. If a stock trades at $10 and it has earnings per share of $5 over the last 12 months, the P/E ratio is 2. This is a rock bottom P/E multiple, and a new value investor might be thinking, “Wow! If I could just hold this stock for 2 years, I would get all my money back. And for every year after that, I will earn another $5 per share!” This might be the case. But the problem is that it is not guaranteed that the company will be able to sustain those earnings.
To better understand the problem, we need to consider the market that sets these stock prices. It’s best to think of the market as the collective opinion of buyers and sellers. It’s a lot like a crowd of people betting on a boxing match. Their betting will influence the payout and implied odds. But these statistics do not reflect reality; they reflect the participants collective ideas of what that reality is.
The stock market is exactly like this boxing match. The buyers and sellers are effectively betting on the likely future outcome of business events. Hence, a low P/E is indicating the general pessimism of the market for that stock. It’s like the stock market is saying out loud “This sucker is going to lose!” If a value investor were to make a contrarian bet on that stock, they are essentially saying that thousands of other people are wrong and they are right. It might be the role of a value investor to investigate this, but they would be wise to proceed with caution and humility. If they take on the challenge, they must be prepared to roll up their sleeves and spend a considerable amount of time doing some careful analysis. If an investor has a critical error in judgement, they might end up owning junk stocks. For a more in depth explanation of these concepts, stay tuned for a future article.
Price to Earnings & Growth
One way of looking at a P/E ratio is to consider the payback time or break-even point if the earnings were to remain the same. If a stock is purchased at $8 while it earns $1 a year, it will take 8 years for investors to get their money back. Any earnings after that period would technically be profit.
But let’s say there is an identical company, Company B, also selling for $8 per share and earning $1 a year per share. The only difference is that this company is growing earnings by 10% a year. Because earnings are growing every year, it would take less than 6 years to break even in this stock.
At first glance these two companies might look like they are equal in value, but it is the one with the higher growth rate that provides more value for the cash paid. The same sort of idea can be applied to companies with negative growth rates. If a company’s earnings are shrinking every year, then it is better to invest in a company with the same P/E ratio but higher growth rate. The table below illustrates the values of companies with similar metrics. Different growth rates will produce greatly different outcomes.
Now we should have a general idea of what a P/E ratio is and how it can be employed as a useful metric when comparing investment opportunities. It should also be clear by now that a P/E ratio is only a slice of the picture when determining which stocks will be likely to produce more value.
A mistake that beginners often make is only looking simple ratios like the P/E. Looking for undervalued stocks can be a lot of work, but it can be worth the effort.
Thank you for reading my article. If you would like to learn more about the concepts and sort of work involved, please follow me on seekingalpha or check out www.valueinvesting.today for more articles.
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