PE ratios: What they tell you (and what they don’t)

What is a P/E Ratio?

The Price-to-Earnings (P/E) ratio is a indicative valuation metric that measures a company’s current share price relative to its earnings per share (EPS). 

It is relatively simple calculation and is simply worked out through dividing the current share price by the Earnings per share.

There are two common variations of the P/E ratio:

1. Trailing P/E: Based on the past 12 months of earnings.
2. Forward P/E: Based on analysts’ forecasts of earnings for the next 12 months.

Why is it Potentially Important?

1. Valuation Insight:The P/E ratio may help investors assess whether a stock is overvalued or undervalued relative to its earnings. In simple terms, a high P/E ratio might indicate that the stock is overvalued, while a low P/E ratio could suggest undervaluation.It is not only the number itself which may be important but also the underlying trend of how PE ratio may be decreasing or increasing which is worth consideration.
2. Comparative Analysis:By comparing the P/E ratios of different companies within the same industry, it is suggested that investors can identify relative bargains or expensive stocks. This issue of the same industry is an important point. If we look at the PE ratio of the S&P500 as a whole the forward 12-month P/E ratio (August 2023) for the S&P 500 is 19.2 (For context the 10 year average is 17.4).However, to look at this number as a benchmark for valuation judgements on a specific company is flawed as if we look at the trailing and forward PE of individual sectors it tells a very different story. The table below provides this (as of August 2023) to illustrate this point (source: Finviz.com).
   

   	PE	Forward PE
   Energy	7.21	9.55
   Financial	13.41	12.34
   Basic Materials	13.74	17.02
   Utilities	18.57	2.97
   Industrials	20.56	16.45
   Healthcare	20.9	17.51
   Consumer Cyclical	22.45	20.93
   Consumer Defensive	23.08	20.49
   Communication	24.9	16.98
   Real Estate	30.72	27.64
   Technology	34.33	22.62

   As you can see, there is a gross disparity between sectors. Comparing two companies’ P/E ratios is like comparing apples with oranges. Therefore, consideration against the sector norm is a far more legitimate comparison than against either the index as a whole, any random stock, or an arbitrary number e.g. above or below 10.

3. Market Sentiment: The P/E ratio also reflects market expectations to some degree. A high P/E ratio may indicate optimism about a company’s growth prospects, while a low P/E ratio might reflect pessimism. However, many would question using P/E ratios alone as a measure of this without the context of other data. Viewing a P/E ratio without some reference to growth numbers and trends is an approach that is unlikely to yield good outcomes.

Factors Contributing to a Rising or Falling P/E Ratio

1. Earnings Growth and Stock Price Movement: Although there are minute-on-minute small fluctuations in price, and thus P/E ratios, clearly the most influential time in terms of moves in P/E ratios is that of earnings releases. At this time, both trailing and expected forward EPS will be recalibrated, and significant changes may be seen in the P/E ratio.If a company’s earnings grow and the stock price stays the same, the P/E ratio will fall, reflecting a company at value. Conversely, if earnings fall and the stock price rises, then the P/E ratio will rise, potentially indicating overvaluation. It would seem logical, if earnings are imminent, to reserve judgment on valuation until after any such news.
2. Market Expectations: If the market becomes more optimistic about a company’s growth prospects, investors might be willing to pay more for the stock, increasing its P/E ratio. For example, with a policy shift to increase renewable energy, it would be reasonable to expect forward growth expectations to rise across the board for all stocks in that sector, rather than perceiving a particular stock as overvalued.However, if growth and P/E ratio are rising because of a specific competitive advantage for that company, then it is not necessarily indicative of overvaluation despite the high P/E. Judging based on a high P/E ratio alone could lead to significant missed opportunities. Once again, this reiterates the need to look beyond just a simple P/E ratio to make judgments.
3. Interest Rates: Lower interest rates often lead to higher P/E ratios, as investors are more inclined to invest in equities. Conversely, higher interest rates usually lead to lower P/E ratios, as bond yields become more attractive than the dividend yield offered by many stocks, and interest rate hikes potentially impact sales, the cost of servicing debt, and subsequent potential impact on earnings.
4. Traditionally, growth stocks are likely to be more interest-rate-sensitive, and therefore the impact on stock price and P/E ratios may differ from sector to sector, and depending on whether business is conducted locally versus globally.
5. Economic Conditions: A strong economy might lead to rising earnings expectations and P/E ratios. Conversely, economic uncertainty or recession might cause P/E ratios to fall. Key data trends are likely to be a useful gauge. This is particularly the case for the “big” data points such as GDP, CPI and jobs data.
6. Other Company-Specific Factors: Changes in management, product launches, legal issues, or other company-specific news can affect both the current stock price and anticipated effect on earnings, thus impacting the P/E ratio.As many of these types of corporate events are unpredictable, when they do occur, it merits not only an evaluation of any prospective investment ideas but also of currently open positions when the P/E ratio may have been part of your decision-making process.

In summary, although the P/E ratio is noteworthy for many investors, judging value and entering a stock with a low P/E ratio requires a rigorous and systematic approach, blending both quantitative and qualitative analysis of the issues discussed above. 

A simple approach of comparing the P/E ratio of one company against another is unlikely to produce good outcomes. Focusing purely on this may mean that a low P/E ratio may be indicative of a company whose outlook is far from favourable, subjecting you to risk.

Conversely, a high P/E ratio alone may not only indicate overvaluation compared to the current price but may also signify a company whose growth prospects are very positive. Ignoring this based on the P/E ratio alone may result in missing out on opportunity.

For those interested in a further exploration of evaluation of stocks with a low PE ratio, we have published an article that may help.“Look before you leap..FIVE reasons why a low PE may be a reason NOT to jump in” and can be accessed HERE