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The price-to-earning (P/E) ratio is a metric that helps you decide if a stock is under or overvalued. Though it’s only one metric among many (and trust us — there are many), the P/E ratio can come in handy when you’re trying to decide if a stock is truly worth its price.
What exactly is the P/E ratio and how can it help you? Let’s break down this nifty metric and see.
What is the price-to-earning (P/E) ratio?
A P/E ratio helps you compare the price of a company’s stock to the same company’s earnings. By making this comparison, you can theoretically evaluate how expensive a stock is. For instance, if a stock’s price is average, but the company’s earnings are very low, then the stock could be a bit pricey. Conversely, if the price of a company’s stock is low and their earnings are high, you might have found a stock that’s on sale. In this case, the P/E ratio may suggest that the stock is undervalued, and you might be able to buy it now at a bargain.
What do low and high (P/E) ratios mean?
Generally speaking, when a company’s P/E ratio is lower than the average for its sector, its stock could be undervalued. Similarly, when a company’s P/E ratio is higher than the average for its sector, its stock might be overvalued.
The emphasis here is on “generally speaking.” P/E ratios are helpful, but they’re not conclusive. While a P/E ratio can give you a rough idea of a stock’s value, you’ll want to do more research to determine if that rough idea is true. Some stocks have high P/E ratios in comparison to their sector’s average, but it doesn’t mean they’re too expensive. Rather, they could be growth stocks that have immense potential. Likewise, just because a stock has a low P/E doesn’t mean it’s an instant bargain. It may have a long history of low P/E ratios, meaning it’s unlikely the stock’s price will ever rise above its peers.
How do you calculate the P/E ratio?
Fortunately, the P/E ratio is simple to calculate. All you need to know is a company’s stock price and its earnings-per-share (EPS). You may have to do a little research to find the EPS, but it shouldn’t take long (a simple web search should do). In fact, most of Canada’s best online brokerages list a company’s EPS when you click on the company’s ticker.
Once you have both numbers, you can find the P/E ratio with the following formula:
P/E = Stock Price / Earnings-Per-Share (EPS)
For example, let’s say Company A has an EPS of $20 and its stock currently trades at $80 a share. In this case, the P/E would be 4 ($80/$20).
How can you use P/E ratios to evaluate stocks?
P/E ratios work best when you’re comparing companies in the same stock market sector. For example, because tech stocks tend to be more aggressive and growth-focused, their P/E ratios tend to be higher than, say, banks. It would be pointless to compare the P/E ratios between companies in these two sectors, as their business models and revenue sources are essentially different.
With this in mind, let’s go back to our example from above. Let’s say Company A is a bank, and its P/E ratio is four. Now, let’s also say Company A has a competitor who is also a bank, Company B. Company B’s stock also trades at $80 per share, but its EPS is much lower, at $5. In this case, the P/E would be 16 ($80/$5).
What does that tell you? Well, for one, it tells you that Company B’s stock is more expensive in comparison to Company A’s, something you wouldn’t have known from the share price alone. With a P/E of 16, investors are paying $16 for every $1 that Company B generates, more than four times what Company A investors are paying ($4 for every $1 earned).
But now let’s take a step back and look at the sector average. In general, the P/E ratio for the financial sector in Canada hovers around 12 to 14. With that range in mind, we can see that Company B’s P/E of 16 falls on the higher end of the spectrum. It could be a growth stock, but it’s certainly more expensive than the industry average. Conversely, we can also see that Company A falls way below the average. Again, it could be an undervalued stock, but it’s not as expensive as other stocks in the industry.
Foolish bottom line on P/E ratios
A P/E ratio is a simple metric that can help you decide if a company is undervalued or overvalued. In essence, it tells you how much investors are willing to pay in order to receive a dollar of the company’s earnings. When used to compare companies of the same sector, it can give you a rough idea of where a company falls in relation to the sector average. It’s by no means conclusive, however, and it’s best used with other valuation metrics.
You can calculate the P/E ratio on your own, or you can check to see if your brokerage does this for you. Many of Canada’s best online brokerages will include P/E ratios in their breakdown of the company, making it fairly easy for you to compare P/E ratios at a glance.
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