I actually began this series of posts by trying to fit the definitions of P/E, P/B, P/S and P/CF in one post. I failed. If you write about P/E and leave out the fact that a low P/E could mean BOTH a great investment or a lousy company, you run the risk of leading someone astray. I’d hate to do that. In fact, I’d rather give a pretty comprehensive overview of these ratios then risk misinforming for the sake of brevity. Therefore, you will get four posts dear reader. Congratulations? I guess? Moving on:
Analysts and stock-pickers love comparing the price of a stock with some other arbitrary company valuation. If you’ve spent any time on Morningstar or Yahoo Finance, you’re guaranteed to see P/E, P/B and will probably see some form of P/S or P/CF. So what do all of these P/X ratios mean? Very simply, Price/Something. The denominator of the ratio changes with the whims of the analyst. You can even make up your own P/X ratio at home. For example, Price/Operating Income. Congratulations. You just added another ratio to the pantheon of P/X ratios. For today, we’ll begin with the every-popular P/E ratio:
P/E or Price/Earnings: Price of the stock per share divided by the earnings per share. This is by far the most common price multiple. Usually anything below 15 is considered cheap, but you must always compare a company’s P/E to some benchmark (preferably industry). P/Es can vary greatly by industry. Some industries like tech and bio-research can have P/Es in the in the triple digits. This means that people are willing to pay $100+ for every dollar that the company earns.
So I hear you thinking “What does that mean?” That means that investors are expecting the company to make a lot more money someday. However, this expectation can keep a stock’s price relatively high for years. Still some people see a high P/E and run the opposite direction and for good reason. When a company has a high P/E, the chances of the company being under-analyzed and under-bought are slim to none. A high P/E means the market is waiting patiently for the company to break out and meet everyone’s earning expectations. However you know what happens when everyone has high expectations for something. When the something fails to meet the expectation, everyone’s disappointment is magnified. Failed expectations are no different in the market.
You also need to compare a company’s P/E with previous years P/Es for the same company, because accountants can greatly inflate one-time yearly earnings (which subsequently lowers P/E). For example:
Is Delta’s P/E actually 3.18? Yep. Is that an accurate representation of Delta’s stock’s value? Absolutely not. In 2013 Delta wrote off nearly $8 million in income tax expense. This write off increased their net income by approximately 10 times the net income of 2012 (which subsequently increased the earnings per share by 10 times). You don’t need a PHD in Math to see what this does to the P/E ratio (30/10 = 3 BUT 30/1 = 30). Remember, when you’re looking at P/E ratios, most of the time you want a lower P/E ratio, otherwise you’re paying for growth.
HOWEVER a low P/E ratio doesn’t guarantee a company is a good buy. The company could just be a lousy investment. You must always take the P/E ratio with a grain of salt. Remember, if choosing a stock was as easy as grabbing a stock with a low P/E then how come everyone isn’t doing it? Because it’s sometimes a poor idea.
All things being equal, you’ll want a low P/E instead of a high one, only because the up-side of a low P/E is infinitely greater than the up-side for a company like Amazon. You want to have high returns on the market, and you accomplish this by choosing stocks that only go up in price.
Finally, if a company earns no money for the year, then the company has no P/E. Take Tesla for example. No profit (yet) so no earnings per share and no P/E.
So, why did it take me a year to understand P/E? It’s extremely simple, but the ratio’s simplicity makes it extremely versatile. Every time you think you understand it, someone will come along and say that “P/E means this!”* and you’ll have to reevaluate everything you thought you knew about the ratio. If it takes you sometime to fully understand it, just keep in mind that I took much longer than the average person, and I blog about it now, so that must mean I know everything there is to know about finance (sarcasm).
*For example, if you flip P/E you arrive at earnings yield, which is another way of stating the percentage of earnings the stock earned per it’s price. Amazon, for example has an earnings yield of .18% (not a typo), while Delta, with its inflated earnings, has an earnings yield of 31.4%. See why you don’t want to purchase a stock with a high P/E?