Stocks with high P/E ratios can be overpriced. Is a stock with a lower P/E always a better investment than a stock with a higher one?

By Chris Gallant AAA
A:

The short answer? No. The long answer? It depends.

The price-to-earnings ratio (P/E ratio) is calculated as a stock's current share price divided by its earnings per share (EPS) for a twelve-month period (usually the last 12 months, or trailing twelve months (TTM)). Most of the P/E ratios you see for publicly-traded stocks are an expression of the stock's current price compared against its previous twelve months' earnings.

A stock trading at $40/share with an EPS (ttm) of $2 would have a P/E of 20 ($40/$2), as would a stock priced at $20/share with an EPS of $1 ($20/$1). These two stocks have the same price-to-earnings valuation - in both cases investors pay $20 for each dollar of earnings.

But, what if a stock earning $1 per share was trading at $40/share? Now we'd have a P/E ratio of 40 instead of 20, which means the investor would be paying $40 to claim a mere $1 of earnings. This seems like a bad deal, but there are several factors which could mitigate this apparent overpricing problem.

First, the company could be expected to grow revenue and earnings much more quickly in the future than companies with a P/E of 20, thus commanding a higher price today for the higher future earnings. Second, suppose the estimated (trailing) earnings of the 40-P/E company are very certain to materialize, whereas the 20-P/E company's future earnings are somewhat uncertain, indicating a higher investment risk. Investors would incur less risk by investing in more certain earnings instead of less certain ones, so the company producing those sure-thing earnings again commands a higher price today.

Secondly, it must also be noted that average P/E ratios tend to vary from industry to industry. Typically, P/E ratios of companies in very stable, mature industries which have more moderate growth potential have lower P/E ratios than companies in relatively young, quick-growing industries with more robust future potential. Thus, when an investor is comparing P/E ratios from two companies as potential investments, it is important to compare companies from the same industry with similar characteristics. Otherwise, if an investor simply purchased stocks with the lowest P/E ratios, they would likely end up with a portfolio full of utilities stocks and similar companies, which would leave them poorly diversified and exposed to more risk than if they had diversified into other industries with higher-than-average P/E ratios. (To read more on P/E ratios, see Understanding The P/E Ratio and Analyze Investments Quickly With Ratios.)

However, this doesn't mean that stocks with high P/E ratios cannot turn out to be good investments. Suppose the same company mentioned earlier with a 40-P/E ratio (stock at $40, earned $1/share last year) was widely expected to earn $4/share in the coming year. This would mean (if the stock price didn't change) the company would have a P/E ratio of only 10 in one year's time ($40/$4), making it appear very inexpensive.

The important thing to remember when looking at P/E ratios as part of your stock analysis is to consider what premium you are paying for a company's earnings today, and determine if the expected growth warrants the premium. Also compare it to its industry peers to see its relative valuation to determine whether the premium is the worth the cost of the investment.

Now that you have an understanding of the P/E ratio in terms of stock valuation, learn how the PEG Ratio can help investors price a company based on its future growth potential in

Move Over P/E, Make Way For The PEG.

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