How To: PE Ratio

PE ratio is the most common and visible financial ratio. It is typically the first valuation metric a common financial site like Google Finance or Yahoo Finance will show you. Despite its popularity, it is not the best valuation multiple to use.

PE ratio is simply the companies market cap/earnings or stock price/earnings per share (same thing).

It is important to note that every financial ratio has its strengths and weaknesses and are only as good as it's inputs. You can read about what makes up these inputs by following the links to How To: Earnings and How to: Market Cap.

I like to think of PE ratio as how many years worth of current earnings would it take for you to own the business whole. If a company has a PE ratio of 15x it would take 15 years, if a company has a PE ratio of 100x it would take 100 years. This illustrates the point that it is generally better to pay a low P/E when buying a stock. This, however, does not take into account the growth of earnings, where paying 100x P/E could end up being cheaper than paying 15x P/E if earnings grow fast enough. That's why PEG ratio (price to earnings growth) is also a popular metric.

Generally, a P/E of under 10x is considered cheap, a P/E between 10-20x is average, a P/E between 20-30x is a little pricy and a P/E over 30x is considered expensive. But this type of analysis very incomplete and more often than not will lead investors to draw the wrong conclusions.

As of this writing the S&P 500 has an average P/E of 22x, compared to the historical average of 15.5x. But due to the rise of intangibles generally understating earnings, a more mature financial system and lower interest rates 22x is not unreasonable.

To summarize the shortfalls of using a market cap and earnings-based metric:

• Earnings can be slightly manipulated, and also misrepresent the cash a business is generating primarily due to intangible investments (like R&D)

• Earnings aims to match revenues with costs in a given time period but ignores when the business actually gets paid leading to situations where companies can be bringing in cash while they have negative earnings. Sounds confusing but Amazon is famous for exploiting this with their cash conversion cycle. (I will have more on this in the future)

• Market cap does not take into account the capital structure of a company, and the assets necessary to generate those earnings. This may make debt laden companies look cheaper than they really are compared to companies with no debt

While PE ratio is the most commonly used ratio, it is not a metric that you should use for financial analysis and should only really be used in casual conversation due to its simplicity.