I remember when I first got into investing. It felt daunting, all the different ratios and terms to learn. A price-to-what ratio?
We all have a tough time getting the hang of something new. Don’t worry about it. This article is for you.
We’ll go over everything you need to know about the P/E ratio:
- What is a price-to-earnings ratio?
- What is it used for?
- How do you calculate it?
- Low and high P/E
- Performance of low vs. high P/E stocks
What is a price-to-earnings ratio?
It’s probably the most basic and commonly used ratio determining if a company is under or overvalued.
Simply put, a P/E ratio is a metric used to determine if a stock is cheap or expensive.
It is calculated by taking the share price and dividing it by the earnings per share.
A stock that costs $100 a share with earnings of $10 a share has a P/E ratio of 10.
This means for every $1 of earnings the company has generated in the last 12 months you pay $10.
Why is that important to know?
Let me illustrate with a weird example.
Let’s say you want to buy some apples, but you don’t know which type. And you’re also very frugal, by the looks of it.
- Apple type A costs $10 for seven apples.
- Apple type B costs $12 for ten apples.
(I have no idea how much an apple cost.)
To decide which one to get, why not use the, ahem… Price-to-apples ratio?
- Type A: Price (10) divided by apples (7) equals a price-to-apples ratio of 1,42.
- Type B: Price (12) divided by apples (10) equals a price-to-apples ratio of 1,2.
In other words, you’re paying $1,42 for one type A apple, and $1,2 for a type B.
That is the essence of the P/E ratio, making things very easily comparable.
High and low P/E ratios
But wait a minute, you say, you didn’t consider anything else. What if the type A apple is superior in taste and texture, as well as being organic?
You are absolutely right. Just because A has a higher ratio doesn’t mean it’s not worth getting.
The same goes for stocks. Two companies can have the same earnings, but one might have a higher price and therefore a higher P/E ratio. Does that automatically mean you should invest in the cheaper one with the lower ratio?
No, it’s not that simple.
Robert’s Robot Lawnmowers had earnings of $3 per share last year and a share price of $45.
Manny’s Manual Lawnmowers also had earnings of $3 per share last year but a share price of $21.
Let’s calculate the P/E.
- Roberts: Price (45) divided by earnings (3) equals 15.
- Manny’s: Price (21) divided by earnings (3) equals 7.
That’s a big difference and also why a price-to-earnings ratio in and of itself isn’t enough. You have to consider many other things when investing.
Things like the growth of earnings, future outlook, product quality, and so on.
You probably guessed that Robert’s and Manny’s are fictional companies but let’s pretend they’re not. Why would there be such a big difference between two companies having the same earnings?
In the real world, we would have to look at a myriad of things, but we’ll keep it simple.
Same earnings but different P/E ratios
What does the history of earnings look like for the two companies?
|Robert’s EPS||Manny’s EPS|
What do you see when you look at the comparison?
I see one company with a steady growth rate and one that is at a standstill, maybe even declining.
Another factor for the difference in price between two companies with the same earnings might be the product. Let’s look at our fictional companies again.
Robert’s Robotic Lawnmowers, big surprise, sells robotic lawnmowers. Every year people are replacing their old lawnmowers with the new robotic kind.
Manny’s sells manual push lawnmowers that don’t even have an engine. While there is a steady stream of people buying them, it is a niche product that will not likely see any growth.
These were just oversimplified examples of why two companies having the same earnings can have very different P/E ratios.
Buying low P/E stocks as a strategy
You would never buy high P/E stocks for the sole reason of them having a high ratio. But what about buying low P/E stocks? Is it a good strategy?
According to a study first presented in The Intelligent Investor, it might be. Now I know this study is old, but more recent studies seem to confirm the same thing.
What Graham’s found was really interesting. The ten lowest P/E stocks significantly outperformed the average thirty and the ten highest from 1937 to 1969, in every period.
Below you will find the results of the study.
|Period||10 Lowest P/E||30 Average||10 Highest P/E|
Other similar strategies found to beat the market is buying low price-to-cash flow (P/CF) and low price-to-book (P/B) stocks. In his book, Contrarian Investment Strategies, David Dreman shows how these strategies not only achieve higher returns in the long run. They also protect your portfolio in bear markets. Outperforming both the average and the highest priced in all the metrics.
We can look at it this way, the highest P/E, P/CF, P/B stocks represent the most favored stocks and the lowest represent the most unfavored. What these statistics show is that investors consistently overvalue favored stocks and undervalue unfavored stocks.
That’s why high ratio stocks are underperforming and low ratio stocks are significantly outperforming.
The price-to-earnings ratio is used to determine if a stock is overvalued or undervalued. Although it’s not the only thing you should look at when choosing between stocks, it’s very useful for comparing them.
Historically, buying low valued stocks has proved to be a solid strategy for beating the market average.