The Price/ Earnings Ratio and Value Investing

By Stock Research Pro • September 9th, 2009

The price-to-earnings (P/E) ratio is used to measure the price an investor would pay for a stock relative to its earnings per share (EPS). The P/E ratio provides a measure of valuation as a higher P/E ratio would mean that investors are paying more for company earnings compared to stocks with lower P/E ratios. The ratio is one of the best known and most frequently used metrics. For value investors especially, the P/E ratio provides a means for assessing the relative appeal of a company’s stock price. In fact, Benjamin Graham (“the father of value investing’) popularized the use of P/E ratios as a quick and easy way to determine relative value.

What is Value Investing?

Value investors are not speculators. Instead, they look to buy shares in companies whose market price is well below the company’s real or “intrinsic” value. Value investors regard stock investing for what it really is- a piece of ownership in a business. Value investors are not too concerned with short-term price swings as they believe that, in the long run, the market corrects itself and the price of their undervalued shares will adjust upward. A review of the price-to-earnings ratio is part of the value investor’s due diligence process.

Calculate the Price-to-Earnings Ratio

The formula for the P/E ratio can be written as:

P/E Ratio = Price per Share / Annual Earnings per Share

Typically, the P/E is calculated using the company’s EPS from the most recent four quarters, also known as the “trailing P/E”. The calculation might instead use the estimated EPS figures over the next four quarters, the “projected P/E”. A third variation which combines the two is sometimes used.

Expect to See Different P/E Ratios for Different Industries

It’s important to note that different industries have different average P/E ratios. For example, high expected growth companies, like those in technology, often see P/E ratios of 40 or higher. Slower growth companies, like manufacturers, many carry a P/E ratio of less than 10. It is the expectations that investors have for the company that determine how much investors are willing to pay for earnings.

Downside to the P/E Ratio for Investors

Much of the downside regarding the use of P/E ratios for investors is about interpretation. As an example, a low P/E ratio does not always indicate a bargain-priced stock. It may be that the stock price has declined for good reason and that investors should be extremely wary. Investors should also beware that company earnings are overseen by accounting rules (Generally Accepted Accounting Principles or “GAAP”) that can and do change over time. Also, advocates of the Price/Earnings to Growth (PEG) ratio argue that the P/E ratio by itself is of limited value as it does not account for expected growth.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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