The Price-Earnings Ratio Revisited

DEAR INVESTOR JUAN
PERSONAL FINANCE 101

10-year P/E ratios as predictors of 20-year annualized returns, as compiled by Prof. Robert Shiller

Dear Investor Juan,

Happy New Year! Kamusta na kayo sa HK?

Sir, it might appear like a silly question but I'm just confused: why is it good if the P/E Ratio is >10? Isn't it that if the earnings per share is higher, the company has good prospects since its generating more revenues (per share)? However, with a higher EPS, the denominator would also be big which will decrease the ratio.

Hoping for your response sir.

Thanks!

Nikko


Dear Nikko,

I'm doing fine here, thank you for asking. Just busy with my research and other things, but of course I always have time for Investor Juan. :)

I have already introduced the price-earnings or P/E ratio in previous posts like this one about stock picking, but I'll use your question as an opportunity to discuss it in greater detail.

First, let me briefly discuss what it is. As the name suggests, the P/E ratio is what you get when you divide a firm's stock price by its earnings per share or EPS (and we get EPS by dividing annual net income by the total number of outstanding shares--the number of shares currently owned by investors). So it's a measure of how much investors value a stock relative to the firm's earnings, and it is used in making personal investment decisions and and valuing stocks or businesses. Since the stock price should reflect a firm's future profitability, strictly the forecast earnings for next year should be used in computing for the P/E ratio. However, for practical purposes people just use current earnings to compute for something called the trailing P/E ratio since that information is what's more readily available.

On its own, the P/E ratio of a stock does not mean anything--it only means something when we compare it to a benchmark, like the P/E ratio of competitors or of the stock market index in the same period, or past P/E ratios of the same company in a time series. So if all we know is that a firm's P/E ratio is 11x (read: eleven times), we can't really say if that is "good" or "bad". What I'm saying is that no finance professor or practitioner worth his or her salt will tell you that "P/E ratio > 10 = GOOD"; even as a rule of thumb, it lacks basis and is therefore useless. So you have to check or question where you got that "rule" from (and write your thoughts in the comments section, if it's all right with you).

But if you know that the P/E of a stock is 11x and that the P/E of the stock index is, say, 13x, then now you have enough information to make some sort of evaluation: at least now you can say that it seems that investors are pricing the stock less than the market as a whole, or that the stock maybe cheap so it may be a good idea for you to buy some shares. But again, it is usually not as simple as that since you would have to consider other things like the state of the industry the company operates in and the firm's other financial and operating characteristics. And even if you are pretty sure that the P/E ratio of a stock is "low," that's not necessarily a good thing.

When would a "high" P/E ratio be "good"?

Investors place a premium on stocks that show promise of high growth in the foreseeable future; in more developed markets like the US, it is not uncommon for "tech stocks" like Google and Apple to fetch P/E's in the neighborhood of 25x and still be considered cheap even if the benchmark index is just at 15x. In general, high-P/E stocks may be considered good (to buy, that is) if:

• Past earnings have shown considerable growth in the past five years or so
• The firm pays little or no dividends and invests heavily in research and development instead (although a few firms like Apple would rather keep a sizable portion of its earnings as cash)
• The firm is in an industry with potential for expansion or reinvention (e.g., the tech industry, in general)

When would a "high" P/E ratio be considered "bad"?

In itself, a high P/E ratio would mean that a stock is relatively expensive for whatever reason, so unless this high price could be justified, it may be best to not buy such stocks for the moment. But sometimes a P/E ratio is high only because earnings are dismally low and investors speculate that the stock will bounce back eventually--and this combination of a failing business and excessive speculation is something investors would want to avoid. In my experience, it happens frequently with "penny stocks" (those that trade for only a few cents a share) as speculators bid the price up often undeservedly and almost always blindly and with mining stocks for which speculation has been rampant and where the possibility of successful operations is often insignificant.

When would a "low" P/E ratio be "good"?

Yes, you're right, if we think about it a low P/E stock with substantial and stable earnings should be a good thing for investors since it would mean that the stock is cheap enough to buy. Good, low-P/E stocks are usually characterized by the following:

• The business has reached the maturity stage of its life cycle and has exhausted all avenues for growth, but remains highly profitable 
• The firm is one of the top players in the market in terms of market share (this and the characteristic above make the firm a "cash cow" in the Boston Consulting Group sense)
• The stock pays regular, stable, and predictable cash dividends

When would a "low" P/E ratio be "bad"?

Sometimes even if the last reported earnings are still quite good, the stock price falls significantly and brings the P/E ratio down with it. This happens when investors come across information that the firm is about to fail; unfortunately for those who are left holding the soon-to-be worthless stock, reported earnings don't reflect material changes in information in real time. So even if you see a P/E that's temptingly low, first make sure that the firm still has a viable business or at least enough assets to justify a purchase.

That's it. I hope I was able to answer your questions satisfactorily, Nikko. Good luck to all your future endeavors. :)