As I have said in many previous articles, you should never buy or sell on a single number, however the P/E is the king of ratios.
A quick review: P/E is calculated by dividing the price per share by the earnings per share. You can use historical earnings, current earnings or projected earnings to get different looks – just be sure if you are comparing the results to other companies you use the same period.
What Market will Pay for StockThe P/E tells you what the market is willing to pay for the company’s earnings.
If a stock has a P/E of 15, that means the market is willing to pay 15 times its earnings for the stock.
For this reason, P/E is sometimes referred to as a multiple. In the above example, the stock has a multiple of 15.
Companies with good growth potential will have a higher P/E because investors are willing to pay a premium for future profits.
High-Risk StocksHigh-risk companies will typically have low P/Es, which means the market is not willing to pay a high price for risk.
Is the P/E system perfect in assigning risk premium to stocks?
Unfortunately, it is not.
The crazy tech market of the late 1990s saw investors putting very high premiums on tech stocks they thought were super-growth companies.
Some of these stocks carried very high P/Es – even though some had never earned a profit – because investors thought the stock would skyrocket.
Stocks CollapsedMany of the stocks did shoot up, but almost all of them came crashing down with disastrous consequences.
An individual company’s P/E can be skewed by accounting abnormalities, such as selling real estate or a division, which temporarily inflate earnings.
For all its faults, P/E remains one of the best ways to judge a stock’s value. You can compare companies in the same industry and look at historical trends.
Don’t make a buy or sell decision strictly on P/E, but it can be a good indicator that a stock is worth studying some more – or not.