By John Drachman
Everyone loves a bargain.
For value investors, the best bargains are those stocks overlooked by a distracted marketplace. As step one in divining stock values, most look first to a company’s price/earnings ratio. Easy to calculate and readily available from published sources, P/E ratios are employed by investors and analysts to compare a particular stock’s “priciness.”
Calculated by dividing a company’s stock price by the company’s earnings per share (EPS), the P/E ratio tells investors how much they would have paid for $1 of company earnings over any prior quarter. A lower P/E today may hint to investors they have a chance at taking part in a greater share of earnings per share tomorrow.
High and lows of P/Es
However, reliance on P/E alone to find value can become difficult. There is no absolute P/E gauge that tells investors what is high or low. According to Wealthsimple’s Aja McClanahan, “It all depends. A lower P/E ratio can mean that companies are using their resources to produce the largest amount of profit possible — which ultimately benefits investors. A high P/E ratio could mean that a stock price is high compared to earnings and might be overvalued.”
While the average S&P 500 Index P/E average is around 15, there are certain industries where the P/E ratio is much higher, like companies in such high-growth categories as technology or bio-tech. Amazon’s (AMZN) P/E, for example, recently stood at 82.78.
On the pro side P/E ratios are:
- Widely used by analysts and investors.
- Easy to compute from just the share price and the EPS (earning per share).
- Signaling growth potential ahead with low P/Es hinting at sustained growth, while high PEs could translate into an M&A opportunity down the road.
- Handy benchmarks for reflecting the marketplace’s actual expectations for a company.
Venture Finance Advisor Ben McClure however cautions investors that P/E ratios may send out false signals, “Judging by how often the P/E ratio gets touted—by Wall Street analysts, the financial media and colleagues at the office water cooler—it’s tempting to think it’s a foolproof tool for making wise stock investment choices,” he said recently. Over-reliance on P/Es in the selection process has its downside:
- P/Es are only based on earnings figures from the past.
- They don’t account for differences in companies that carry a lot of debt – or cash – on their balance sheet versus those that don’t.
- Accounting policies can vary from company to company, making P/E comparisons less than dependable.
To firm up their value convictions, investors can use other metrics in the analytical tool belt like the Price/Earnings to Growth ratio (PEG) that also factors in a company’s expected earnings growth over a given period or the Trailing P/E ratio that takes a full 12 months of earnings into account.
The Bottom Line
No single combination of ratios can tell you all you need to know about a stock. An experienced financial professional with access to the appropriate research though can help to evaluate your assumptions, check your math and collaborate with you on future stock selections.
John Drachman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. John is an IABC award-winning writer, who applies his 30 years of financial marketing experience toward advancing the dialog between investors and investment professionals.