Low or High P/E Ratio: Which Is Better?
What Is a Good P/E Ratio?
Many investors’ first action when looking at potential or current stocks is to look at their current trading price and past performance, followed by the price-to-earnings (P/E) ratio. However, many times, investors are unsure how to make a decision based on this ratio.
Is a low P/E ratio good or bad? Is a high P/E ratio good? These are valid questions to ask, but the answers depend on you. To make things less confusing, I will break down how the P/E ratio should be used based on different investment strategies and how it can be applied to your own decision-making process.
What Is the Price-to-Earnings (P/E) Ratio?
The price-to-earnings ratio is a formula used to compare a stock valuation to the company’s industry peers and the overall market. Investors use this ratio to determine if a stock is overvalued or undervalued and to obtain insight on how much of a multiple is being paid based on the company’s earnings.
The formula for the P/E ratio is as follows:
Price-to-earnings (P/E) = current trading price ÷ 12-months earnings
The equation simply takes the current trading price of a stock and divides it by the annual earnings of a company.
Below is an example of how to use the equation, including comparisons to competitors and the S&P 500 Index. The reason that the S&P 500 P/E ratio is used is because it is known as the broadest index, with 500 companies in many different industries.
|Stock||Industry Average||Price-to-Earnings (P/E)||Current Trading Price||Annual Earnings of Company||Valuation|
|S&P 500 P/E Ratio = 26|
Price-to-earnings (P/E) = $250.00 ÷ $10.00 = 25
The P/E calculation would show that the stock is trading in line with both its industry peers and the S&P 500 and represents a fair value.
If an ownership stake was thought about in this stock, then a multiple of 25 would be applied. This would mean that for each dollar of earnings, $25.00 would be paid out.
Price-to-earnings (P/E) = $50.00 ÷ $5.00 = 10
Based on the P/E ratio, the stock is trading at a discount. This stock would be of interest to a value investor, who would believe that if the investment is right for them, it should be trading at a higher multiple and be in line with others in the industry.
From the three stocks in this example, stock B is trading at the cheapest valuation. There would be only be $10.00 paid for each dollar of earnings that the company generates.
Price-to-earnings (P/E) = $40.00 ÷ $1.00= 40
This would be a stock that is overvalued on a relative basis and would be favored by growth investors. The reason for the higher valuation is because investors believe a lot of future positivity is likely. The revenue and earnings are expected to grow at a higher rate than those of the market and industry peers.
Stock C would represent the most expensive stock since $40.00 would be paid for each dollar of earnings.
Invest in Low P/E or High P/E Ratio Stocks?
The answer to this question will depend on you, since it is based on your investment objectives, goals, and expected returns.
If you are looking for returns that are greater than the overall market, then you are a growth investor. This would involve looking at companies that have a high P/E ratio in comparison to the usual suspects.
The market expects that these companies, which tend to be the in startup or growth stages, are going to grow their revenue and earnings very quickly. There are times that a stock will have a high P/E because the good news that is expected is already built into the stock. And as long as that good news continues, the high ratio should remain. But do note that since a higher return would be expected, there would be more risk associated with the investment.
On the other end of the spectrum, there will be stocks that a low P/E ratio; these companies would be considered undervalued. A stock could have a low P/E for a few reasons, one being that investors are simply staying away from the company and the sector it is a part of, since other areas are seeing a greater potential for returns. Other possibilities include little-to-no growth and a lot of capital is being used to reinvest into the business due to changes in the sector.
When you own a stock with a low P/E ratio, there will be less risk involved because a lower multiple will be paid for the company’s earnings. Investing into such a company requires a contrarian point of view, since you would be investing before the market, ignoring this company, realized it’s trading at a discount.
On the other hand, when it comes to investing in a company with low or high P/E, it depends on your risk tolerance level and the return you would like to see in relation to that risk.
There will be times where one strategy outperforms the other. For example, in a market that is flat or down, low P/E stocks should outperform, while high P/E stocks will do better in a booming market.
One option is to take advantage of the market conditions, buying low-P/E stocks in a down or flat market, and high-P/E stocks in one performing well. This way, you get the best of both worlds.
Why Is the P/E Ratio Important?
Using the P/E ratio will save a of time when researching for a stock. If you are a growth investor the focus would be on companies with a higher P/E multiple and a value investor would only considered companies with a low P/E ratio. Depending what type of investor you are; you will only focus on what meets your P/E ratio criteria.
The first step of using the P/E ratio is by taking a look at the stock that you are considering for an investment. Then it is compared to its industry peers. The comparison is made with industry peers because companies in the same sector tend to see the same economic factor on revenue and earnings. Also the gross and net margins typically are in same range.
Let’s say you have a particular stock in mind that you are considering to invest into and you begin your research on the company. By looking at the P/E ratio of the company you come to realize that the stock does not fit your investment return goals and objective.
However, you really want exposure to the sector that the company is part of. Since you took the time to research the first investment opportunity and the sector you end up finding a company that would actually fit right in your investment criteria.
So, there could always be other investment opportunities that are more appealing and would suit you better. By not looking at the sector of companies the investment opportunity could have been missed.
What Is the Difference Between Trailing P/E and Forward P/E?
The ratio can be used two different ways: as a trailing P/E and as a forward P/E.
The only difference between these two ratios is the annual earnings that is used to determine them. The trailing P/E ratio uses earnings reported over the last 12 months and is the most commonly used version of the P/E ratio.
The forward P/E ratio uses forecasted earnings for the next 12 months. The information is provided by either the company itself or an analyst researching it. The business would determine future earnings based on projections (and assumptions) of its heads. An analyst, meanwhile, would give a forecast on earnings because it’s their job to look at a company and the industry it operates in.
As an investor, I would suggest using both versions of the P/E ratio. Both can give you insight on how the company is viewed, one internally and one from the outside.
For instance, if a trailing P/E ratio is lower than a forward P/E ratio, it means analysts on bearish on the company. It could be interpreted as meaning that the stock has gotten ahead of itself or that there is no earnings growth, serving as a warning sign for investors.
If the trailing P/E ratio is higher than the forward P/E ratio, it signals to the markets that the view on the company is bullish. There should then be upside ahead, with expected earnings growth.
What Is a Negative Price-to-Earnings (P/E) Ratio?
It is possible for a company to have a negative price-to-earnings ratio.
Now, the P/E equation represents the current trading price, and it is impossible for a stock to trade below zero. Therefore, the current trading price cannot make the equation negative.
However, earnings, the latter part of the equation, could be in the red, with the company losing money on a per-share basis. This is the result of the business spending more money than it is bringing in.
When the P/E ratio is negative, investors tend to look to other areas of the business to determine if an investment is appropriate.
Final Thoughts About Low or High P/E Ratio
Using the price-to-earnings ratio is a great first step if you are considering a stock. However, don’t forget to also look at aspects such as management’s performance, new services or products, and the company’s financial statements.
No matter if you are looking to invest in low or high P/E ratio stocks, a great strategy is to also consider dividend-paying stocks, which will see you get paid for holding on to an investment. But if you were going to only focus on dividend-paying stocks, more research would be needed to ensure the dividend is safe.