Using the P/E

November 5, 2007 at 8:16 am · Filed Under Educational 

A lot of people know that P/E stands for the Price/Earnings ratio, but a lot of people don’t really know how to use the number.  Obviously, the P/E means almost nothing to short term traders, but for investors, it can be an important number to take into account.  A neophyte might see that a stock has a P/E of 50 and immediately assume it’s overpriced.  Like most other numbers in stocks though, a single value doesn’t give the whole picture – you need to look at the context of the number.

The first thing you should care about is what kinds of numbers other companies in the industry are pulling.  Some industries will have very low averages, like oil refining right now with their P/E of 11.  Other industries will be very high, like internet companies with their current average of 77.  Knowing what the competition does is a vital step in researching a company, and seeing how the P/E’s stack up is one of the things you should be comparing.

After you have an idea of what the industry standards are, you should start comparing historical P/E’s for the company.  With growth stocks, the P/E will usually be on the higher side, since people are pricing in the growth.  A stock that’s gone up 500% over a few years might still be underpriced if the earnings have been exceeding the share price ramp up.  The time to start worrying about a hot growth stock is when the P/E starts surpassing the P/E the stock had when it broke out of its first base.  When looking for value stocks, similar rules apply.  You should make sure you aren’t buying a stock that’s getting cheaper for a reason.

For a growth example, let’s say company XYZ starts out with an EPS of $0.20 and a share price of $10, for a P/E of 50.  A couple years later, let’s say they’re making $0.40 a share with a share price of $20, holding their P/E of 50.  If the company’s prospects still look good, it would be worthwhile to note this as a potential buy candidate on a breakout.  After the company’s been rolling for a couple more years, they might be making $1.00 a share, but the hype will have built up and their price will have also exploded up to $75, for a P/E of 75 now.  This is definitely a time to be wary and either take your profits or set some tighter stops (although the correction may gap down through your stop and you’ll take a larger hit than hoped for). 

The numbers for XYZ were based on a real company, but go ahead and look at some hot stocks you can think of from the past and you’ll see the same pattern.  During the growth phase, the P/E slowly creeps upwards until the stock has a large correction, after which the P/E usually doesn’t ever get back up to that peak again.  After that growth phase is over, the low points in the P/E were likely good times for value purchases. 

One last thing to remember is that earnings are only quarterly events, so a P/E chart will be quite gappy.  It pretty much just follows the stock upwards, but hopefully jumps back downwards every quarter due to earnings increasing (not due to the price of the stock decreasing).  Learning to use the P/E will give you yet another indicator to look at when deciding if you want to make a play on a stock.  As with any other indicator, it’s not going to give definitive buy/sell signals that are always correct, but it can provide some valuable information to be used along with the other numbers you usually look at.

Comments

2 Responses to “Using the P/E”

  1. dmoney on November 5th, 2007 2:12 pm

    Where are you getting the historical p/e ratio chart?

  2. lamdar on November 5th, 2007 8:17 pm

    I normally get the historical P/E off the charts at TD Ameritrade (but you’ll have to have an account to do that). I think it’s also currently offered at bigcharts.com or marketwatch.com too. Or you could always calculate it yourself roughly when looking at the income sheets by calculating how much the EPS has grown and then looking at how much the stock price has grown.