Understanding P/E Ratios: A Comprehensive Guide

Price/earnings (P/E) ratios are a common measure of stock value, both for individual stocks and the overall market. Calculating a P/E ratio is straightforward - it is simply the price of a single share of stock divided by the company's per share earnings. For example, a stock selling at $50 per share with $2 per share of earnings would have a P/E ratio of 25. However, P/E ratios can be calculated using different earnings numbers. Trailing P/E ratios, which are typically reported in newspapers, use earnings per share for the most recent four quarters, while forward P/E ratios use forecasts of future earnings per share.

To understand what a P/E ratio represents, consider what it means in terms of how much you would pay for a business you want to purchase. The value of that business would be largely determined by how much income it generates and how long it would take to recover the purchase price with that income. You might be willing to pay four or five times earnings (for a P/E ratio of 4 or 5), realizing it would take that many years to recover the purchase price. However, if you felt earnings had the potential to increase significantly in future years, you might be willing to pay a higher multiple of current-year earnings.

When considering public companies, it seems reasonable that well-established businesses growing in a fairly predictable pattern would command a higher P/E ratio than a small private business. Since you don't have the risks or responsibilities that come with owning a business, you would probably pay a premium. Typically, companies with higher growth rates command higher P/E ratios.

The difficulty is deciding what a reasonable P/E ratio is for a particular company or for the overall stock market. For individual companies, investors' expectations about future earnings affect the P/E ratio. Confidence that a company will improve its profitability or remain profitable generally results in a higher P/E ratio. If profits are threatened or weak, the P/E ratio is likely to drop. P/E ratios for the overall market change based on broad market conditions and investors' views about how desirable stocks are compared to other investments.

There is no absolute measure of what P/E ratio should be paid for a given company with a given growth rate. P/E ratios can fluctuate significantly over time and among companies and industries. It generally helps to follow the P/E ratios of stocks that interest you, along with companies in similar industries, to develop a feel for how the P/E ratios fluctuate. Reviewing a company's P/E ratio for prior years can also be helpful. If a company's growth rate in the past is expected to continue in the future and market conditions are similar, you might not expect much change in P/E ratios. But you also must evaluate whether changes to the company, its industry, or the overall stock market would cause an increase or decrease in the company's P/E ratio.

One way to evaluate P/E ratios is to consider a company's current P/E ratio divided by its historical P/E ratio. If it is much lower than 1, you might want to investigate why. It could mean the business is in decline or having other problems. It may also imply that the stock is reasonably priced now. If the value is much higher than 1, carefully assess whether you want to invest at this time. You may want to wait until the P/E ratio returns to a more historical level.

You can also divide a company's current P/E ratio by the market's overall P/E ratio. If that figure is much higher than 1 (and thus higher than the overall market), you should evaluate whether the company's prospects justify that valuation.