There are two key factors that influence a stock’s performance. The first is the profitability of the underlying company. The second is how investors value that profitability. An earnings report can tell you something about how well the business is performing, however, it does not tell you anything about investors’ perceptions regarding the company’s performance. One way to measure this is the price-to-earnings ratio (or P/E for short).
Components of P/E ratio
The P/E for a stock is computed by dividing the price of the stock by the company’s annual earnings per share. If a stock is trading at $20 per share and its earnings per share are $1, then the stock has a P/E of 20 ($20 / $1). Likewise, if a stock is trading at $20 a share and its earning per share are $2, then the stock is said to be trading at a P/E of 10 ($20/$2).
Enthusiasm on the part of investors can lead to “P/E Expansion,” while a lack of enthusiasm on the part of investors can result in “P/E Contraction.” P/E Expansion refers to a period when investors’ perceptions improve, and as a result, they are willing to pay more for a dollar’s worth of earnings. P/E Contraction refers to a period when investors’ perceptions worsen, and as a result they are willing to pay less for a dollar’s worth of earnings. For example, if the average P/E ratio for stocks overall rises from 16 to 20, while overall earnings remain relatively unchanged, this is an example of “P/E Expansion.”
What traders look for
Different companies and different industry groups can be awarded very different P/E ratios even if they are generating the same level of profit per share. In other words, two companies may both report earnings of $1 per share, but one stock will trade at $20 a share while the other trades at $30 a share. This can be due in part to the consistency of earnings, the anticipation for future increases in earnings and the industry group that each stock is in. If investors are excited about the prospects for a given company they may be willing to accept a higher P/E ratio in order to buy its shares. On the other end of the spectrum, if investors feel that future earnings will be underwhelming, its P/E ratio may languish at a relatively low level.
The key thing to look for is whether the current P/E for the stock of a given company is presently “high” or “low.” The tricky part is that there are arbitrary cutoff levels that qualify as “high” or “low.” The best way to assess a company’s P/E is by:
1. Comparing the current P/E to the history of the company’s own P/E range.
2. If appropriate, comparing the company’s current P/E to that of other similar companies (i.e., other companies in the same business or industry group).
In general, if the current P/E is at the lower end of a company’s own historical P/E range, or if the company’s current P/E is below the average P/E of similar companies, it may be a sign that regardless of recent business performance, the stock may be undervalued.
What traders look out for
The best case scenario for any stock is for the underlying company to consistently grow its earnings, for investors to become enthusiastic about the company’s long-term prospects and to value its earnings at a high level – i.e., with an above average P/E ratio. That being said, emotional buying and selling at the extremes can force stocks to overbought or oversold levels.
On the down side, a stock can become very “cheap” based on its P/E ratio. And while it may or may not represent an excellent value at that price, the stock may not rebound in any meaningful way until investors perceive there to be some catalyst. In addition, there can be situations where a company has a low P/E ratio simply because its future earnings prospects are dim. This can create a “value trap,” where a stock looks cheap by comparison but demonstrates in the future that there was a reason it was cheap.
As a stock’s price rises, investors need to pay close attention when a stock gets bid up to an excessively high P/E level. In the heat of a bull market it is not uncommon to find “hot” stocks trading at a P/E of 50 or more. While this can go on for some time, eventually the stock’s price may drop. And when a “hot stock” falls from grace, the ensuing price decline can be swift and painful.
Stock analysis using the P/E ratio
The P/E ratio can tell you a great deal about what investors overall think of a given stock. However, to accurately assess whether a stock is overvalued or undervalued, it is necessary to compare the current P/E to previous P/E ratios as well as P/E ratios of other companies in the same industry.
Likewise, while exceptionally low or high P/E ratios can highlight potential opportunity or potential danger, stocks can sometimes continue to move to increasingly undervalued or overvalued levels for an extended period of time before things reverse.