Investment Knowledge: What is the PE Ratio?
And what are its limits?
The Price-to-Earnings (PE) Ratio is often the first valuation metric we encounter when studying stocks. However, it can be misleading, even for experienced investors. In this article, we will define the PE Ratio and explore its limitations.
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Definition of the PE Ratio
The PE Ratio is a simple metric that indicates how many years of earnings it would take to buy the company at its current price.
The formula to calculate the PE Ratio is as follows:
PE Ratio = market capitalization / net income
Alternatively, you also have:
PE Ratio = market price per share / earnings per share (EPS)
So basically, a high PE means that the stock is expensive and a low PE means that the stock is cheap. But is it that simple? Not at all!
You can calculate the PE in the past using historical data or in the future using analyst consensus (or your own estimates).
The lower the better?
So, if you are wondering whether the lowest PE is always the best investment, the answer is no, it’s not that simple. Many factors can explain or justify a particular valuation, such as (non exhaustive list):
Growth
Market
Market share
Competitive advantage
Balance sheet
Profitability
Resilience
Margin increase
Brand value
Therefore, the best returns don't always come from low-PE companies. Otherwise, industries like car manufacturing, minerals, or oil & gas would dominate the market returns.
Additionally, for the PE ratio to be meaningful, a company needs to have reached a maturity level where it has positive (and stable) margins. For a young company with still-low margins, the PE ratio can be misleading. Highly cyclical companies may also experience significant fluctuations in their PE ratio due to changes in their margins. In such cases, the PE ratio is not the best metric to evaluate their valuation.
Then, how to use the PE?
The PE ratio is most relevant in the following situations:
Mature and profitable companies. It works best for established companies with stable and consistent earnings.
Comparing companies in the same industry or sector. It helps evaluate how a company stacks up against its peers in terms of valuation.
When earnings growth is stable. For companies with predictable and steady earnings growth, the PE ratio is a useful tool for assessing valuation.
Assessing valuation relative to historical data. It can help determine whether a company is expensive or cheap based on its past performance.
However, the PE ratio is less relevant in these cases:
Early-stage companies. Startups or companies with minimal or negative earnings can lead to misleading PE ratios.
Cyclical industries or companies with irregular earnings. Industries like oil, gas, or mining, with highly fluctuating earnings, make the PE ratio less reliable for valuation.
Another use of the PE ratio: index valuation
At an aggregated level, PE ratio can also be used to identify whether a whole sector or an index is expensive - compared to its previous value. Of course EPS growth is a main factor to take into account for this kind of analysis.
Is higher always better?
At times, it may seem like PE ratios (or even valuations) don’t matter, and that strong returns are possible regardless. However, this is a misconception.
If we zoom out, we can see that buying when markets are expensive typically leads to lower returns.
Of course, I stand by my earlier point: the primary driver of long-term returns is EPS growth. However, valuation represents the risk/reward ratio of an investment.
So, aiming for the lowest PE isn’t necessarily a good strategy, and aiming for the highest is certainly not advisable. Using the PE ratio as a reference and comparison tool is likely the wisest approach!
Conclusion
So, we have covered what the PE ratio is, how it is calculated, when it is useful, and when it can be misleading.
Like any ratio, the PE ratio is most valuable when used as part of a more comprehensive analysis, alongside other ratios and performance metrics. And we will dive into that in the upcoming articles!
What are your thoughts on the PE ratio? Share that in the comments!
If you liked this article and enjoy Quality Stocks, spread the word!
The evolution of PE ratios is fascinating. That chart at the end is particularly fascinating. Did you make it yourself? And do you have data for recent years?
I know your blog is all about how to manage investments -- but I come at this from a public finance background -- so I have to ask another question:
Why are PE ratios so high these days?
Merci pour cet article ! Le PE ratio est un bon point de départ, mais il ne doit pas être utilisé seul. Il est essentiel de considérer d'autres facteurs, comme la croissance des bénéfices, la stabilité du secteur, ou la position d'une entreprise sur son marché. Comparer le PE d'entreprises du même secteur peut être pertinent, mais encore faut-il prendre en compte leurs spécificités. /********/Thanks for this article! The PE ratio is a good starting point, but it shouldn't be used on its own. It's essential to consider other factors, such as earnings growth, industry stability, and a company's position in its market. Comparing the PE ratio of companies within the same sector can be useful, but it’s important to account for their specificities.