PE Ratio (Price-to-Earnings) is a valuation ratio that compares the price per share of a company’s stock to its earnings per share.
It basically shows how much investors are willing to pay for a share given the earnings currently generated.
It is also used to analyze whether a stock is overvalued or undervalued.
How to use the PE Ratio:
- The PE Ratio by itself is just a number and not very useful.
- When we compare PE ratios between companies and industries, we really start getting the picture for the particular company we are analyzing.
- It does not make much sense to compare PE Ratios of companies across different industries, as each industry has its own unique way of conducting business.
- It’s like comparing a doctor with an engineer to see which one is more valuable.
- Hence, if comparing PE ratios, they should be compared between companies in the same or similar industries.
- You can also compare the PE ratio of a company to the PE Ratio of the entire industry that it operates in to analyze whether the stock is over or under-valued.
How to interpret the PE Ratio
High P/E Ratio may mean:
- Market sentiment: An overly optimistic PE Ratio can indicate the market expects big things from this company. The company has high growth possibilities.
- Lifecycle: The company could be entering into the Growth or Shake-Out stage of its lifecycle.
- Industry: A PE Ratio could be representative of the industry the company is. For example most technology companies have high PE Ratios.
- Cover priced or over-bought: A high PE Ratio can indicate a given stock is priced to high and ready for a correction.
- This means that it might be over-valued.
- Be sure to compare against industry norms.
Low P/E Ratio may mean:
- Lack of confidence: A low PE Ratio may indicate a lack of confidence in the future of the company.
- Lifecycle: The company could be in the Mature or Decline stage of its lifecycle.
- Industry: A PE Ratio could be representative of the industry the company is. For example most utility companies have low PE Ratios.
- Sleeper: A low PE Ratio might be a sleeper just waiting to be discovered. This means that it might be undervalued, and a perfect time to start buying the shares.
Coca-Cola and Pepsi operate in the same industry and produce goods that are very similar in nature.
- Coca Cola’s (KO:NYSE) stock price (Price per Share): $66
- Coca-Cola’s Earnings-per share (EPS): $5.26
- Coca-Cola’s PE Ratio: $66 / $5.26 = 12.55
- Pepsi’s (PEP:NYSE) stock price (Price per Share): $69
- Pepsi’s Earnings-per share (EPS): $3.73
- Pepsi’s PE Ratio: ($66 / $5.26) = 18.50
From our calculations, we can see that Pepsi has a higher PE Ratio than Coca-Cola.
This could be perceived a couple of different ways:
- Coca-Cola is under-valued and should be bought.
- Pepsi is over-valued and should be sold or shorted.
- Investors do not perceive Coca-Cola as doing as well as Pepsi presently.
- Pepsi is launching a new product that Coca-Cola is not.
The truth is normally some combination of these perceptions.
Over time, and with additional research, one can potentially pinpoint the exact occurrence and make a lot of money by trading according to his or her analysis.
- The Earnings-Per-Share in the PE Ratio formula is a number that comes from the accounting books of the company.
- Hence, it is possible to manipulate the EPS underlying the PE Ratio in order to trick investors into perceiving the stock differently.
- It is important to independently verify that the company’s’ financial statements are sound and true.
A PE Ratio is an important valuation tool that can give key insights into whether a stock may be over or under-valued.