Once every three months, investment analysts and CNBC talking heads get to celebrate earnings season, when publicly traded companies must make their quarterly conference calls to investors. During these calls, companies report their earnings from the previous quarter and make projections for the future. Using this information (but not only this information), analysts form their opinions and give price targets on the stock of the reporting firm.
Earnings are an important measure for both company executives and stock analysts. After all, if a company is losing money, it’s probably not a good investment, right? The Price-to-Earnings (P/E) ratio is a fundamental way to measure these earnings against the stock price of the company in order to make a value judgment.
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How Are P/E Ratios Calculated?
The formula for calculating a P/E ratio is simple and straightforward. You take the share price of the company and divide it by the earnings per share, or EPS number.
For example, let’s say that company ABC is trading at $25 per share. In their quarterly earnings call, ABC reports EPS of 2.5, meaning the company made $2.50 of profit for every outstanding share of stock. In this instance, ABC would have a P/E ratio of 10 since 25 / 2.50 = 10.
In traditional fundamental analysis, investors look for stocks with low P/E ratios. The idea goes that if a company has a low P/E ratio, its share price hasn’t yet caught up to the firm’s profit-making potential. Likewise, if a company has a high P/E ratio, the shares might be overvalued since they don’t properly reflect the cash the company is taking in.
Two methods are used to measure P/E ratios:
- Trailing P/E is the most commonly used metric, the one you’ll see listed next to the share price on your brokerage app screen. This number is the price of the stock divided by the last 12 months of earnings, or trailing twelve months (TTM) for short.
- Forward P/E uses earnings guidance to project future ratios.
Benefits of Using P/E Ratio in Stock Analysis
Here are the benefits of using the P/E ratio to evaluate stocks:
- Simple structure – Using the P/E ratio to evaluate stocks is useful for both veteran and novice investors since it’s an easy concept to understand and formulate. Earnings reports are provided every three months on the dot, giving investors updated information on a timely basis. Using P/E helps to calculate an estimate of the return an investor might expect to earn for each dollar they invest.
- Easy comparisons – Evaluating companies across different industries can be difficult because not every business operates in the same fashion. Grocery stores have notoriously thin margins, utilities are heavily regulated, and oil drillers require tons of upfront capital to get their operations underway. All three of these types of companies have different goals and benchmarks to meet, but P/E ratios allow a simple comparison between them.
Limitations of P/E Ratios
Here are the drawbacks of using the P/E ratio to evaluate stocks:
- Poor measure of growth – Renowned value investors like Benjamin Graham were known to avoid companies with P/E ratios above 20, but the market landscape looks different today than it did in Graham’s time. Growth stocks dominate the market and the P/E ratio does a notoriously poor job accounting for the growth prospects of startups who are spending money as quickly as they make it. Using a strict methodology like no stocks over 20 P/E would eliminate some of the biggest winners of the last few decades, such as Amazon and Facebook. Expensive doesn’t always mean overvalued.
- Fails to account for debt – A company with a low P/E ratio isn’t an automatic buy. You’ll still need to dig through balance sheets and make sure those earnings are supported by a strong financial foundation. If a company with a P/E ratio of 10x is burdened by bad debt coming due soon, the affordability of the shares today probably won’t matter.
Use More Than Just P/E Ratios
Like any type of financial measuring stick, P/E ratios can be useful tools when used properly, but you’ll need more than a single ratio in your toolbox. While easy to understand and simple to calculate, P/E ratios ignore many factors crucial to the future potential of a company, like growth rates and debt levels. Additionally, earnings totals are susceptible to creative accounting practices since company executives have perverse incentives to surpass the estimates supplied by analysts. Metrics like forward P/E and trailing P/E are necessary and enlightening in stock evaluations, but never rely on a single indicator for your investment decisions. Contact your advisor today to learn more about how utilizing fundamental signals like P/E ratios can help you become a better investor.
Work With an Experienced Financial Advisor
The Price-to-Earnings (P/E) ratio is a fundamental tool for analyzing stocks. If you have any questions, reach out to a team member from Good Life Financial Advisors of Mount Pleasant today! We’re happy to assist you.
The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.