Grasp the Price to Earnings Ratio

This newsletter is designed to help investors understand the price-to-earnings ratio. A CFE Finances customer recently asked a great question: is a P/E ratio of 1 the best P/E ratio? It is a terrific question, so let’s dive in. A P/E ratio of 1 would suggest the stock is deeply out of favor — possibly undervalued — while still reflecting strong earnings and solid value. For example, if a stock trades at $10 and the company earns $10 per share, the P/E ratio is 1. Those are excellent earnings for such a low price, but a P/E that low typically signals that investors simply are not buying the stock. In practice, however, this example almost never occurs: a company generating $10 of earnings per share would have a much higher stock price because the business is highly profitable. Earnings per share (EPS) is calculated by dividing net earnings by the number of outstanding shares. For a P/E ratio to remain healthy relative to peers, the stock price needs to appreciate in step with earnings growth, which requires investors to actually like and buy the stock.

Think of the P/E ratio as a fundamental measure: as the P/E rises, it often reflects a stock price that is appreciating on the back of strong sales and earnings. Another way to read it is emotional — a high P/E can mean the stock is in favor and buyers are willing to pay a premium. When a company has no P/E at all, it is because it has no earnings. In those cases, investors are buying the story: strong sales, a growing customer base, and a belief the company will be profitable later. How does a company operate with no earnings? By using stock equity and cash flow to fund operations and growth. That relates to a concept we’ll cover another time: market capitalization.

You can also view the P/E ratio as what you, the investor, pay for each dollar the company earns. A P/E of 10 effectively means you are paying $10 for every $1 of current earnings. When the P/E is too high, we say the stock is expensive. Before buying or selling, always compare companies within the same sector or industry. If you are researching Home Depot, compare it to Lowe’s: look at both Home Depot (HD) and Lowe’s (LOW) for their five-year average P/E and current P/E. You can calculate a P/E ratio yourself or find it on a Value Line survey. A good rule of thumb: buy a stock when its P/E is below its five-year average, and consider selling when the P/E becomes roughly 1.25 times the P/E at which you bought in. Good luck and happy investing from CFE Finances! We will be in touch with another newsletter soon. If you have any questions or concerns, please email us from our contact page.