OK class, investing 101 is in session. What is a PE ratio – or P/E ratio as it is sometimes referred to? If you said “price to earnings ratio,” you get partial credit. But more important to your investing strategy is exactly what that investing catch phrase means and what a PE ratio calculates for stocks.
In simplest terms, a PE ratio is a valuation of a company’s current stock price compared with its full-year earnings per share. This allows investors to compare companies of different sizes and in different sectors along the same investment playing field. While PE ratios for stocks indeed have an industry norm — for instance, many biotech startups have high PE ratios because they have not yet won approval for a drug and are therefore not making much money yet – this measure is helpful as a rule of thumb to tell you how “expensive” or “cheap” a stock is.
Take Apple Inc. (AAPL). The company’s current market value per share is around $265. For the full fiscal year of 2010, Apple is expected to earn about $13.50 a share. 265 divided by 13.5 gives you around 19.6 – the current PE ratio for Apple.
There are variations on price to earnings ratios, of course. Some investors use trailing earnings because these are actual profits per share instead of Wall Street estimates. Others use future EPS since investors should be buying the stock based on the outlook going forward instead of past and current performance. Still another variation is to annualize earnings per share based on a single quarter instead of taking each quarter’s earnings independently.
Now that we have the basics down, what is a good PE ratio for a stock? Strictly speaking, anything between 15 to 25 is a decent valuation. When companies have PE numbers in the single-digits, they tend to be seen as good buys by investors who watch this ratio. When a stock gets around 30 or 35, generally investors who watch PE ratios think the company is overpriced.
The rule isn’t foolproof, but it is helpful when plotting an investment strategy or a simple trading strategy for your retirement money.
To give you some concrete examples, here are three overvalued stocks according to these PE ratio guidelines, and three bargain investments to buy based on their current price to earnings makeup:
High PE Ratios – Three Overbought Stocks (VMC, HOT, WYNN)
Vulcan Materials (VMC) has a PE ratio of around 170 right now after two straight quarterly losses – included a shortfall of -35 cents per share in the first quarter. Vulcan sells “aggregates” to the construction industry including crushed stone, sand, gravel and concrete, and the lack of building recently thanks to a harsh housing market has really hurt VMC. The full-year earnings estimate for Vulcan is a mere 28 cents per share. Divide the current stock price of around $48 by that figure, and you get a fairly ludicrous PE ratio.
Starwood Hotels & Resorts (HOT) also has very high PE ratio, but not as bad as VMC. With shares of HOT stock around $50 and full-year earnings expected to come in at 94 cents, that gives this stock a PE ratio of more than 50 – double that of what most investors consider a good valuation. The interesting thing is that unlike Vulcan, Starwood Hotels appears to be a victim of its own success and overenthusiastic buying that has gotten ahead of proper stock pricing. Thanks to a 550% earnings surprise for the first quarter and improving numbers, the stock has raced up about +35% year-to-date. Those who watch PE ratios may say that HOT stock is overbought due to this high valuation right now.
Wynn Resorts (WYNN) seems to be in the same boat as Starwood, with a PE ratio of round 80. Shares of WYNN stock are trading for around $86, and the full-year earnings estimate for this stock is around $1.10. Investors have bid up WYNN on the prospect of a recovery, as well as big expansions in the Chinese gambling mecca of Macau. But for those who pay attention to PE ratios, WYNN stock may be overvalued after a gain of nearly +50% since January 1.
Low PE Ratios – Three Bargain Stocks (GME, F, DELL)
GameStop (GME) is a video game retailer that many investors have turned away from as game sales have slumped and consumer spending remains thin. But GameStop continues to put up great numbers and is trading at a bargain PE ratio of under 8 right now. At less than $20 a share and with projected earnings of $2.60 for the year, GME could be a good bargain stock to buy for investors watching price to earnings ratios. What’s more, GameStop has met or exceeded Wall Street expectations in the last three quarters so it’s not unrealistic to think that full-year earnings could be even better than forecasts for GME stock.
Ford Motor Co. (F) seems to be losing favor with investors despite its breakout performance in 2009. Folks are afraid that the year-over-year comparisons for the automaker will only get harder and that the lion’s share of the gains in market share made after the bankruptcy of GM and Chrysler have already been baked into shares. However, with a full-year profit forecast around $1.30 a share and current pricing of around $11.60, Ford puts up a PE ratio of less than 9. That could mean Ford is a great bargain buy for investors.
Dell (DELL), the computer manufacturer that was trading for $40 a share in 2005 and hasn’t topped $25 a share except for a brief uptick in 2008, is far from the dominator it was five years ago. However, with full-year earnings projected at about $1.30 a share and DELL stock currently trading under $14, the PE of about 10 could mean that Dell is at last a good buy again for investors who watch price to earnings ratios.
One word of caution: Since earnings estimates are fluid and share prices are even more so, it is important to always make sure you have the latest information before making a trade based on price to earnings ratios. What’s more, remember that earnings estimates are exactly that – estimates. If a stock is trading at a bargain PE ratio based on a lofty earnings outlook but then falls dramatically short, it turns out the company was probably properly valued all along.
That said, PE ratios can be invaluable to determining whether a stock is overbought or whether it might just be oversold. Investors would be wise to add price to earnings data to their checklist when formulating an investing strategy.
As of this writing, Jeff Reeves owned a long position in GameStop.