The P/E ratio is the relationship between the price of a stock and the company’s earnings. P/E ratios are widely followed and are important barometers of value in stock picking. The P/E ratio is also called the earnings multiple, or simply the multiple. It is often used to determine if a stock is expensive or inexpensive.
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What is the P/E Ratio?
The P/E ratio answers the question: “How much am I paying for the company’s earnings?”
P/E ratio = Price (per share) / Earnings (per share)
When you buy a company, you’re really buying its power to make money. In essence, you’re buying its earnings or net profit.
Value and Growth Investing
Value investors find the P/E ratios and other metrics essential for analyzing a stock as a potential investment, and typically look for stocks with lower P/E ratios. Growth investors use similar metrics, but often tolerate higher P/E ratios.
Value stocks, at least in theory, are considered lower-risk and less volatile because they are usually found among larger, more established companies. Even if the stocks don’t return to the target price investors predict, they may still offer some capital growth, while many pay dividends.
Growth stocks, meanwhile, usually refrain from paying out dividends. Instead, they reinvest retained earnings back into the company to expand. Growth stocks have a higher risk, especially if a company fails to meet growth expectations.
It should be noted that over shorter periods, the performance of both growth and value will also depend in large part on the stage of the cycle the market is in. Growth stocks are more volatile and usually outperform during bull markets. Value tends to do better during market downturns and corrections.
Avoid Errors When Evaluating P/E Ratios
When evaluating stocks by industry, don’t assume the one with the lowest P/E ratio is always undervalued and therefore a more attractive purchase. The reality is, the lowest P/E usually belongs to the company with the worst earnings history.
If a company’s P/E ratio changes in the near future, it’s because conditions, events, psychology, and earnings have continued to improve or deteriorate. Eventually, a stock’s P/E will reach a peak, but this normally occurs when the market averages are topping and starting to decline, or when the company’s earnings growth is about to weaken.
Reliance on P/E ratios often ignores basic trends. To say that a stock is undervalued because it traded at a P/E ratio of 24 and is now trading at 15 times earnings can often be naive. This simple truth is that stocks usually trade at their current value.
Long-Term Performance
Many studies show that value investing has outperformed the growth style over the long term. But looking at more recent data, value did outperform for the first 10 years of the 2000s, but growth outperformed over the last 10 years. Dividends likely play a key role in helping value outperform over longer periods.1
The Bottom Line
The decision to invest in growth vs. value stocks is ultimately left to an individual investor’s preferences, risk tolerance, investment goals, and time horizon. P/E ratios for Company Overviews are posted in reports at stockmark101.com.
This article is for general informational and educational purposes only. It is not intended as financial advice, investment guidance, or a recommendation to buy or sell any security. The content reflects publicly available information and broad market commentary. Readers should conduct their own research and consult a licensed financial professional before making investment decisions.