What is a P/E Ratio?
The Price-to-Earnings ratio, commonly called the P/E ratio, can be defined as a company's stock price divided by its earnings per share from the previous 12 months. Generally, lower ratios are considered better for someone looking for a bargain, but a higher P/E ratio can indicate a company has very high growth expectations. So both high and low P/E's can be good depending on how an investor interprets the ratio, as well as how it is used within the evaluation process.
A quick surge in growth of a company's stock price, while earnings remain relatively unchanged, might cause a high P/E multiple. Whereas, the opposite is true when a company experiences a dramatic drop in share price. Furthermore, a sudden jump in earnings from the previous quarter can reduce the P/E ratio, with the reverse of that held true when a company's quarterly earnings go down in value. Note, both earnings scenarios assume the stock price remains relatively stable.
How to Use p/E Ratios
The best way to use a P/E ratio for stock analysis is as a supplement when comparing companies within the same sector or industry. However, it is a bad idea to use P/E multiples to benchmark a technology company to a consumer staples company. In other words, avoid using the ratio if evaluating companies that are in two different sectors. Apples-to-apples versus apples to oranges.
Also, solely relying on this ratio for stock analysis is a rookie investor mistake. In fact, doing so can be a big value trap and mislead an investor into thinking they are buying a stock at a bargain because XYZ company's P/E ratio is a 6 versus their peer average of 24. Due to the fact the P/E ratio uses historical earnings, it is not necessarily a great indication of a company's ability to generate earnings growth in the future. In fact, a relatively low or negative P/E ratio might indicate the company is heading for trouble.
A better option for investors who prefer to account for future growth prospects is the Forward P/E. The Forward P/E ratio is similar to the P/E ratio, except that E = future earnings in the next 12 months. However, the problem with the Forward P/E is that one has to make some guesses and assumptions about the future growth prospects of the company under consideration. Wall Street analysts often miss on their estimates, so that is why you might see higher fluctuations of price movements when a company announces their quarterly earnings. Beat analyst expectations and the company's price shoots up, but fall short and the stock price often falls.
The best-in-class of all the types of P/E ratios is considered to be the Shiller P/E. This ratio was named after Nobel Prize-winning economist Robert Shiller, the creator who made the ratio popular among investment professionals. According to Money Magazine, the Shiller P/E is "the best and most widely regarded indicator of future returns." A study by Vanguard determined that the Shiller P/E ratio has a stronger correlation with stock gains over the next decade than the other P/E ratios most frequently referenced. In addition, the Shiller P/E is often used as a way to uncover undervalued segments of the market.
The conclusion investors should draw upon from the P/E ratio is that it is one of many analytical tools to use whenever evaluating a stock's relative value and future growth prospects.