Many investors on Wall Street consider the price-to-earnings ratio to be a key valuation. The P/E ratio is the metric that just about everyone talks about, and yet, a lot of investors out there don’t know what the P/E ratio is and, most importantly, how reliable it is.
Let me help clear things up.
The P/E ratio helps gauge the relative value of a stock by comparing its price (“P”) with earnings per share (“E”). To calculate P/E, take the monthly averages of a stock’s daily share price, and divide it by the last 12 months’ worth of earnings per share.
You can also calculate a forward P/E, in which you would use earnings-per-share projections for the rest of the year or even the following year.
Let me give you an example using Pier 1 Imports Inc (NYSE:PIR). Over the last four quarters, PIR has posted earnings of 20 cents a share, 10 cents a share, 16 cents a share and 41 cents a share, which leaves us with a total of 87 cents a share over 12 months. The average share price of PIR is $13.11. You then take that share price and divide it by the earnings to get the P/E, which is 15 in this case.
But what does this tell us? It really depends on the company you’re evaluating. It’s very important that you take into account the P/E ratios of similar companies as well as those within the same sector or industry.
Does P/E Work?
One of the hot debates on Wall Street has been and always will be how important the P/E ratio metric really is. If you take a look at a chart that compares P/E ratios and the broad market indices, you’ll see that there appears to be a correlation between peaks in P/E ratios and a “top” in market trading action.
A correlation is certainly the case in some circumstances, but the P/E is no foolproof crystal ball. I don’t believe it is possible to use P/E ratios to pinpoint market peaks. In fact, a lot of times, the year’s best performing stocks are those with higher P/E ratios.
There’s another metric I pay attention to — sometimes more than the P/E ratio — to help me assess valuation while also factoring in growth. It’s called the price/earnings-to-growth ratio. It’s important to keep in mind that PEG ratios are more applicable in some industries than others.
For example, PEG ratios may work better when evaluating technology companies that are growing revenues but aren’t necessarily making a lot of money yet. P/E ratios, on the other hand, may be better when evaluating companies like utilities that don’t see a lot of top-line growth but are generating a lot of cash on the bottom line.
The P/E and PEG ratios are tools in any investor’s toolbox, and I don’t rely on just one or two — I like to use a lot of them. That being said, I believe fundamental influences are most important — how and/or what a company is doing.
Is the company growing the top line organically? Does it have pricing power? Are its margins expanding? And if so, is that carrying down to the bottom line? Charts and technical metrics also play a role in my analysis, especially in determining buy and sell points.
As you grow as an investor, you’ll come up with a process that works best for you. Even better, if you’re not comfortable going it alone, I’m here to help. I’ll have more details for you soon, though I can tell you it will include my very best, most immediately actionable investment ideas and active portfolio guidance you simply can’t get anywhere else — at least short of enrolling as an institutional client of my independent research at a cost of thousands per year.
I encourage you to stay focused on being a part owner in great companies and to look for value and growth in your stocks. The P/E and PEG ratios are two tools that can help you do that.
As of this writing, Charles Payne did not hold a position in any of the aforementioned securities.
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