Stock analysis is a complex process.
Some metrics, like the P/E ratio, are particularly difficult to interpret. If you’re just getting started, it can be overwhelming.
But we’re here to help.
There’s no magical ratio that tells you whether to buy certain stocks. The metric is nuanced, and its interpretation requires some understanding.
All the same, there are useful rules and tricks that can help retrieve meaningful information.
Here’s how to determine what a good P/E ratio is.
What Does P/E Ratio Mean?
Before we dive deep into the analysis, let’s see what P/E is.
The price-to-earnings ratio, also known as price multiple or earnings multiple, measures the market value of a stock relative to its earnings per share (EPS).
In other words, it shows how much you’re paying for $1 of earnings. In addition, it reveals crucial information about investors’ interest in a company and its financial performance.
Ultimately, a P/E ratio is what can help you determine whether a stock is undervalued or overvalued.
What Is a Good Price-to-Earnings Ratio
There’s no straightforward answer to that question.
First, we need to determine what is considered high or low. Then, we can decide whether it’s a good P/E ratio or not.
The average price multiple across all industries is 20-25. But it’ll be an oversimplification to say that everything below that is low and above it is high.
We need the industry average or historical P/E to determine that.
Generally, a high ratio indicates that investors believe the stock earnings will grow. In contrast, a low ratio suggests that growth may slow down.
However, that’s not always the case.
Low P/E Ratio Stocks
Low ratios can be interpreted as either good or bad.
On one hand, they could be a sign of decreasing growth. Even if the price for a unit of earnings is reasonable now, it isn’t worth it if the company’s financial performance seems to be declining.
On the other hand, a low ratio could be an indicator of “value” shares—stocks of high value with low prices. If other metrics suggest a company has growth potential, it could mean the stock is underpriced.
To determine which of the two scenarios is more likely, you need to conduct further analysis.
High P/E Ratio Stocks
High ratios reveal an increase in stock purchases. This could mean that investors see growth potential in a company and expect a higher EPS in the future.
That said, you should always compare businesses from the same industry. If the ratio of a company is disproportionately higher, the stock may be overvalued.
Whether you perceive the P/E of a stock as overvalued or a worthy investment will often depend on your investment strategy and style.
Of course, you also need other metrics and comparisons to evaluate stocks properly.
Here’s how you can use the earnings multiple to do that.
Analyzing Industry P/E Ratios
Comparing a price multiple to the industry average can give you an idea of how the company stacks up against other businesses in its niche.
Just note that you can’t make comparisons across different sectors.
A look at the average P/E ratio by industry will reveal why.
The price multiples in IT, for example, are much higher than those of utility companies. So, a low P/E in the IT context may be high in the utility sector.
As such, you always need to examine the earnings multiple in a broader context to see if it’s undervalued or overvalued.
Analyzing Historical P/E Ratios
Apart from individual stocks, you can analyze market indices. That way, you can evaluate the index’s performance over time or the companies included in it.
The latter is a common application of the historical P/E.
Let’s take the history of the S&P 500 P/E ratio as an example.
The index has been around since the 1800s. Back then, its average earnings multiple was around 16. Its value has fluctuated a lot, with an all-time low of five and a peak of 124.
In July 2022, its ratio was 21.95. The S&P 500 forward 12 months P/E is expected to fall down to 17.12 in the following year.
Given the looming economic crisis, that drop isn’t surprising. And since knowing how the ratio has varied over time, we can be confident that change isn’t alarming.
Analyzing Trailing vs. Forward P/E Ratios
A P/E ratio calculator could be helpful (most financial websites publish them), but you will need to understand how they work to interpret the numbers.
Most importantly, you must distinguish between the different types of earnings multiples.
The main ones are a forward and a trailing P/E.
The former is based on the company’s projections of its future performance, also known as forward earnings guidance. It is an estimate of the price-to-earnings ratio based on predicted earnings.
The latter is the P/E for the past year based on the trailing 12 months (TTM). You can calculate it using data from the past four quarters or the previous fiscal year.
You can also come across the terms “absolute” and “relative” P/E. The meaning of an absolute P/E ratio is what we just described above.
The relative ratio is expressed as a percentage. It’s a company’s P/E divided by the industry average or historical P/E.
Whether you’re calculating the ratios on your own or looking for information on financial platforms, you need to be aware of the metrics used to make accurate comparisons.
Wrap Up
So, what is a good P/E ratio? As with most things in life, it depends.
A price multiple can show you how expensive a stock is compared to the industry average or its own past performance.
Hopefully, our guide helped you build the necessary context for proper interpretation.
With an eye for research, Aleksandra is determined to always get to the bottom of things. If there’s a glitch in the system, she’ll find it and make sure you know about it.
