How to Properly Use The P/E Ratio When Analyzing A Company
What is the P/E Ratio?
Price to Earnings or PE ratio is known as the first valuation ratio that many investors will use to very quickly get a picture of how expensive the stock market is pricing a public company. Although it is very useful to perform this quick screen of valuation with Price to Earnings, PE, it's sole purpose when used correctly should only be used to understand two things:
You are not over-paying a high multiple for their earnings.
The company has a solid income statement. If they have a negative PE, this means they have operated at a loss over the last trailing twelve months. Negative PE and negative earnings indicate either a struggling business, or a pre-earnings company that is still unprofitable in their trailing twelve months.
First, lets break down what this ratio is calculating:
PE = Current Market Share Price / Earnings per Share
The advantage of PE and why it is so widely used is because it can be used to avoid expensive companies and since earnings is the denominator, you can avoid companies with weak profitability (negative PE or negative earnings). It can be used as a double edged sword.
For example, if company X currently trades at a PE of 15, investors are pricing the stock at 15 times the earnings per share. This can be interpreted as a payback period in years if their earnings were not going to change over time. This is obviously not the case in the world of business, and is the reason for companies trading at higher earnings multiples. The market predicts that the company will be able to grow their bottom line very effectively in the future.
What range of earnings multiples, or PE, do intelligent investors find attractive?
I say "range" because since the only function of PE is to screen out expensive stocks and stocks with negative earnings. An attractively low PE ratio should never be the sole reason for an investing decision. Much more research is required among evaluating other valuation ratios like P/S, P/B, P/FC, evaluating revenues, return on equity, debt to equity, payout ratio, qualitative moats, and more.
A word about Negative PE
A negative PE ratio indicates the company has negative earnings or simply put, is losing money. Recall, PE = Current Market Share Price / Earnings per Share. If earnings per share (EPS) is < 0, the company will have a negative price to earnings ratio.
The great Benjamin Graham, Warren Buffet's mentor at Columbia University, suggested buying companies trading at a PE of less than 15. This is simply a good rule of thumb. I recommend screening for stocks trading at PE less than 25. Don’t forget this includes PE > 0 as I recommend buying profitable companies with positive not negative earnings. This will be a good place to start. Sometimes we are able to find opportunities of growth at a reasonable price. The lower the PE, the better. But, sometimes a fantastic company trades at a higher valuation for good reason. The point of this screening exercise is to simply avoid companies trading at extreme PE 50+.
How do I use PE to Screen the Market?
I have written a blog post for How to Screen for Stocks on the Toronto Stock Exchange to walk investors step by step in the Canadian Market. I recommend using finviz.com for the rest of the world.