The Price-to-Earnings ratio explained.

The price-to-earnings ratio is a “valuation metric” used to value a company’s share price relative to its earnings per share (EPS). It is one of the most used valuation ratios by investors to determine if a stock is undervalued or overvalued.

When you buy a share of a business you are buying a stake in the future earnings of that business. The price-to-earnings simply relates to the current share and what investors will pay for every dollar of the company’s earnings.

A lower P/E ratio typically means investors are willing to pay less for each dollar of the company’s earnings. A higher P/E means investors are willing to pay a premium for a company’s earnings. The price-to-earnings ratio can be used in two ways both forward-looking and a trailing (rear-view) outlook on the company.

The price-to-earnings ratio although the most widely used ratio does not give an investor a clear look at the business especially if we consider industries, the stage of the business, and other important factors. A lot of investors will simply filter based on P/E multiples as a part of their screening process. Filter for a lower P/E if you are looking for a value play and filter for a higher P/E if you are looking for a hyper-growth idea.

Like all the other ratios it needs to be compared against like-for-like companies in the same industry, sector, and more importantly stage of the business cycle. We would not compare an early-stage hyper-growth technology company to a multi-billion-dollar mature business.

Some businesses deserve a lower price-to-earnings and are low for a reason and some higher, what seems like outrageous price-to-earnings are warranted due to the company’s projected growth and the opportunities around its future.

The ratio is a multiple that tells the investor “How many times the price covers the earnings” and indicates how many years the earnings will take to pay off the price, assuming consistency in profits.

If a P/E is 10 it means you are paying $10 for every $1 of current earnings or it would take 10 years (if earnings stayed constant) for the company to have enough profit to recoup the share price.

What is the Price-to-Earnings formula?

• P/E = Price per share ÷  Earnings Per Share
• Earnings Per Share = A company’s profit divided by the outstanding shares of its common stock.

How to use the P/E ratio?

The price-to-earnings ratio is better suited to mature companies, with positive earnings and companies with very similar market caps and capital structures. If an EPS is negative the price-to-earnings will be very inaccurate so understanding the business cycle is important. If there are no profits because the investment idea is an early-stage or hyper-growth company, then using other ratios like the Price-to-Sales ratio will be better.

Let’s compare three companies and calculate the price-to-earnings ratio for each to asses what looks like the better prospect.

	Company A	Company B	Company C
Current Share Price	$27.50	$22	$19.50
Earnings Per Share	$2.50	$3.87	$0.75
Price-to-Earnings:	11	5.68	26

In this simplified example, we have three companies and the reflective P/E below. Let us assume the industry average has a P/E of 12 and these companies are all similar sizes and operations.

Company A $27.50 ÷ $2.50 = 11

Company B $22 ÷ $3.87 = 5.68

Company C $19.50 ÷ $0.75 = 26

What can these numbers tell us? If the industry benchmark is around 12 we can see that Company A is on par with the industry average and fairly valued. Company B is undervalued significantly and Company C is overvalued and considered expensive compared to the industry and its peers. Company C indicates investors’ optimism as they are willing to pay $26 times every $ dollar of earnings.

The way to view this example is to ask first of all, what makes Company B undervalued and what makes Company C overvalued? In theory, a stock’s P/E should equal the company’s growth rate. If Company C is growing at 26% annually then is it overvalued? If earnings per share creep up to its competitors it will bring the P/E in line with the industry average. Investors may be more optimistic about the growth rate of Company C hence why it commands a premium.

What makes a high price-to-earnings high is all based on one question. Can this company achieve its forecasted growth earnings, because if it can is it overvalued? When looking at the undervalued business we have to asses is the underlying business in trouble, have things changed for the business? Sometimes a business misses earnings and goes through a tough period and the lower P/E reflects this drop in earnings and as a result, the market punishes the stock.

However, if the growth opportunities of the business have not changed too much and the average price-to-earnings of Company B is around the industry average of 12, then it could represent a value play as it reverts to the mean. The other idea investors need to invert is sometimes the lower price-to-earnings ratio say of Company B at 5.68 is considered Overvalued if that company has limited room to grow further.

High price-to-earnings ratio.

A higher ratio may suggest that the company is overvalued or investors are optimistic about the company’s future earnings growth. Companies with high price-to-earnings are often associated with growth stocks.

Low price-to-earnings ratio.

A lower ratio may suggest the company is either undervalued or investors expect earnings to decline, which is most often found with declining growth prospects as the company reaches maturity. If investors are pessimistic about future earnings then it is something to consider.

Value Trap or Bubble Burst?

The issue with the price-to-earnings ratio and using it as a “fixed idea” is where I see most investors go wrong. “It is Low there for cheap, it is high there for overvalued”. This is the wrong way to look at an investment idea purely based on numbers. If we are running computer algorithms and investing based on mathematical equations then fair enough. Build a portfolio of low P/E stocks (Deep Value Fund), or a Hyper Growth fund of higher P/E stocks, and away you go.

As investors, this is not how we should view valuation ratios (or any ratio) without the context of the underlying business. A value trap can occur with ultra-low price-to-earnings for a reason as a company declines after passing maturity. A bubble can and often does burst on higher P/E stocks as one missed earnings call attracts an analyst’s downgrade and it all comes crashing down pretty fast.

Ultra-low P/Es of less than 5 I have yet to see make turnarounds and even as a “Cigar But” play, I typically avoid them at all costs. Higher price-to-earnings of well over 100 (I recently saw a bio-pharma company with a P/E of 300) I also just steer clear from, my mind just does not see a company growing at 300% annually and I fear significantly overpaying for what hope has already been priced in.

In Summary…

I don’t filter ideas based on the price-to-earnings ratio as I look for quality companies that can stand the test of time. I invest in both low and high P/E businesses based on growth outlooks, underlying business fundamentals, and market expectations. It’s important to research and identify true growth opportunities to separate hype from reality. I buy high price-to-earnings if my research indicates it can meet or exceed those earnings. I buy cheap quality companies when “Mr Market” has a mood swing and I can get a great business for a better price. That is just smart investing.

Doing the work and looking beneath to see what is happening can put the multiples into perspective.