For years, the price to earnings ratio or the relationship between a stock’s price and the earnings of the underlying company has been a standard metric for traders. For this reason, the price to earnings ratio is always included in quotes from online brokers and free sites like Yahoo Finance, along with the earnings per share ratio, the stock’s 52-week high and low, and other basic information. More recently, however, some analysts have suggested that the very ubiquity of the p/e multiple (as it’s sometimes called) has reduced its effectiveness as a valuation tool.
The argument here is that markets immediately incorporate known information in the price of any traded security. This means that the price to earnings ratio can’t tell you anything about the stock that everyone else doesn’t already know. Furthermore, if you don’t know anything that isn’t widely known, how on earth (as an amateur) will you compete with Wall Street types, who will always have superior access to information?
The answers to this question are simpler than you think—and sometimes deceptively simple.
For one thing, you might know something that Wall Street doesn’t know, like that a manufacturer in your region is expanding at break-neck speed, or that the new presentation E-board in the school where you teach has been very well received.
For another, Wall Street analysis isn’t always what you think. Professional money managers are sometimes as lazy as anyone else (or as gullible, foolhardy, or wrong). You can know something they don’t because they’re just wrong and you’re right, or because you bothered with an area of research that they neglected. In other words, the p/e multiple may be telling you a stock is cheap when everyone else thinks it’s reasonably valued. If you’re right, you make money and they lose down the road when you sell your stock to them for more than you paid.
Generally, the usefulness of the price to earnings ratio depends on how and where it is used. The multiple can’t tell you much about the stocks of certain retailers (which trade on same store sales) or miners (which trade on net asset value) or newer issues that have yet to show a profit. For many stocks, however, the p/e ratio is a marvelous tool when combined with other metrics and uncommon common sense.
Here are three ways to use a stock’s p/e multiple to decide if the stock is undervalued or richly priced:
Compare the price to earnings ratio of your stock to the company’s annual growth rate
The growth rate is the increase or decrease in a company’s earnings per share from one fiscal year to the next. For example, if your company made $1 per share last year and is expected to earn $1.15 for this period, we would say that the enterprise is growing at 15%–an enviable rate for any business anywhere. However, as in theory the growth rate should equal the multiple, if the p/e ratio of your stock is only 10 or 11, you may have found a diamond in the dirt. At this point, the most important question to ask is why the multiple is lagging the growth rate. Has the company recently issued additional shares, thereby temporarily depressing the stock’s price? Are the company’s earnings expected to decline in the near- to medium-term or do sales in the industry typically trough in the winter or spring?
Many financial sites provide information on industry groups, including the stock prices and earnings per share of direct competitors. Are the p/e ratios of other players higher or lower than your stock’s? Does your company’s multiple stick out like a sore thumb? If a competitor has a much higher multiple than your stock (say, 28 versus 10 for your company), it’s likely that the competitor’s earnings are increasing at a faster rate, or that expectations for this competitor are lofty.
Compare the p/e ratio of your stock with the ratios of competitors in the space
If your stock’s price to earnings ratio is lower than the ratios of similar companies, again, you need to ask why. Has there recently been a management change that’s affecting the share price? Does the company own assets in a less politically stable part of the world?
Some companies will provide historical data, such as average annual ratios, on the investor relations page on the corporation’s site. Although all publicly traded companies publish this information in annual reports, you may need to do some digging to find it.
Compare your stock’s price to earnings ratio with the ratio in previous years
How does today’s multiple compare with prior years? If it’s higher, do earnings increases justify the current stock price? If the multiple is lower, does it reflect an earnings decline and how will the slide be reversed?
Again, asking why the multiple has changed is more important than mulling over the numbers. Anyone can find the numbers, but putting them together in the right way is the art of uncovering patterns and trends. It’s also the heart of stock analysis, which is still more art than science and still requires more imagination than basic math. Despite the claims of certain market makers that the p/e ratio no longer matters, it remains an important measure for those who give it a context. The context could be anything from a stock’s sector to share price history. It might even be a fickle market or a slowing economy. Curiously, you hear more claims that p/e ratios don’t matter when ratios are very high or low. During the tech bubble, for instance, multiples were ‘stretched’ to reflect the ‘unlimited’ potential of new technologies in a smaller world. Then, again, in the bear market of ’08 to ’09, we were told that low multiples meant nothing. We were told that the price to earnings ratios of some perfectly respectable names could never return to historical norms. It’s hard to say how multiples have staged the recovery we see today when a few years ago they supposedly signaled a new era of meager earnings and lackluster stock market returns.