Some traders believe the higher the price/earnings ratio (P/E), the better. But the opposite is true. The P/E multiple represents the number of years' net income represented in the current price per share; so the higher the P/E, the more inflated market expectations.
P/E is computed by dividing price per share by earnings per share. The result, the multiple, is expressed as a round number without a percentage sign. For example, if price is $52.30 per share and EPS is $3.65 per share, P/E is 14:
52.30 ÷ 3.65 = 14
Note that the EPS is equal to 14 years worth of profits, based on the latest reported earnings. So the EPS would have to be earned for 14 years in order for the earnings to come out to the current price. This is why the P/E is referred to as a multiple.
As a rule of thumb, a moderate P/E will be somewhere between 10 and 25. If P/E is lower than 10, it indicates lack of interest in the company among investors. But if P/E is higher than 25, it probably means the current price is too high. For this reason, limiting a search to mid-range P/E stocks (between 10 and 25) is sensible. Why would anyone want to pay more than retail? The ideal situation is to find a bargain-priced stock, one near the low range of a moderate P/E.
P/E is not the simple and reliable indicator it might seem to be, either. It combines a technical indicator (price) with a fundamental (earnings). The problem is that price is very current, but earnings is likely to be three months old, or older. So the two indicators are out of sync, making reliance on P/E a risky decision. For this reason, some analysts like to use forward P/E, which is based on current estimates of earnings for the coming year. The problem with this is that is relies on an estimate; and if you follow any stocks, you know that estimates can be very misleading.
The solution is to analyze a range of annual P/E results from high to low, over an extended period. Five years is good, ten years is better for this purpose. If the P/E remains consistent within a range over several years, it is reliable and represents a consistent and reasonable price for shares. If you see P/E bouncing from high to low in a broad range or extremely inconsistent over a period of time, it means the fundamental volatility is too high and cannot be depended upon. It could also be a signal that earnings decisions, even within the allowed range of discretion, are being tinkered with each year. If you see the range of annual P/E rising over the period under study, it reveals the likelihood that the current price per share is too high. Seek a bargain in a company whose P/E is between 10 and 25 and stays within that range year after year.
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