Stock Analysis Using the P/E Ratio

There are two key factors that influence a stock's performance: the profitability of the underlying company and how investors value that profitability. An earnings report can tell you about the profitability part but not the value that investors place on those profits. One way to determine a stock's value is by comparing its share price to the company's earnings, a measurement known as the price-to-earnings ratio (or P/E for short).

The P/E for a stock is computed by dividing the price of a stock (the "P") by the company's annual earnings per share (the "E"). If a stock is trading at $20 per share and its earnings per share are $1, then the stock has a P/E of 20 ($20/$1). Likewise, if a stock is trading at $20 a share and its earning per share are $2, then the stock is said to be trading at a P/E of 10 ($20/$2).

Enthusiasm on the part of investors can lead to P/E expansion—a period when investors' perceptions of a company improve, and as a result, they are willing to pay more for a dollar's worth of earnings. For example, let's say a stock that was trading at $80 per share is now $100 per share. The earnings per share (the "E" part of the equation) has remained at $5, but because of investors' optimism, the average P/E ratio rises from 16 to 20. 

Conversely, when investors' perception of a stock worsens and they are looking to pay less for a dollar's worth of earnings, P/E contraction occurs. The stock's price falls (even though the earnings per share remains stable) and the P/E ratio moves lower. 

As a result of all this, companies and industry groups generating the same level of earnings per share can be awarded very different P/E ratios. For example, two companies may both report earnings of $2 per share, but the stock trading at $20 a share has a P/E ratio of 10 while the other trading at $30 a share has a P/E of 15.

This can be due in part to the consistency of earnings, the anticipation for increased earnings, and the industry group that each stock is in. If investors are excited about the prospects for a given company, they may be willing to accept a higher P/E ratio in order to buy its shares. On the other end of the spectrum, if investors feel that future earnings will be underwhelming, a stock's P/E ratio may languish at a relatively low level.

The key is to look at whether the current P/E ratio for the stock of a given company is presently "high" or "low." The tricky part is that there are arbitrary cutoff levels that qualify as "high" or "low." The best way to assess a company's P/E ratio is by:

1. Comparing the company's current P/E to its historical P/E range
2. If appropriate, comparing the company's current P/E to that of similar companies in the same business or industry group

In general, if the company's current P/E is at the lower end of its historical P/E range or below the average P/E of similar companies, it may be a sign that the stock is undervalued—regardless of recent business performance.

The best-case scenario for any stock is for the underlying company to consistently grow its earnings and for investors to become enthusiastic about the company's long-term prospects and to value its earnings at a high level—resulting in an above average P/E ratio. That being said, emotional buying and selling at the extremes can force stocks into overbought or oversold levels.

When a company's P/E ratio falls, a stock can become relatively "cheap." And while its P/E may or may not represent an excellent value at that price, the stock may not rebound in any meaningful way until investors perceive there to be some catalyst. In addition, there can be situations where a company has a low P/E ratio simply because its future earnings prospects are dim. This can create a "value trap," where a stock looks cheap by comparison but demonstrates in the future that there was a reason for its low price.

If a stock's price rises, you need to pay close attention when a stock gets bid up to an excessively high P/E level. In the heat of a bull market, it's not uncommon to find "hot" stocks trading at a P/E of 50 or more. While this can go on for some time, eventually the stock's price may drop. And when a "hot stock" falls out of favor, the ensuing price decline can be swift and painful.

The P/E ratio can tell you a great deal about what investors overall think of a given stock. However, to accurately assess whether a stock is relatively overvalued or undervalued, it's necessary to compare the current P/E to that stock's previous P/E ratios as well as the P/E ratios of other companies in the same industry.

Likewise, while exceptionally low or high P/E ratios can highlight potential opportunity or a potential danger, stocks can sometimes continue to move to increasingly undervalued or overvalued levels for an extended period of time before things reverse. Do your research or consult a financial advisor before making a trade.