Everybody’s heard the common investment aphorism “buy low, sell high,” but how do you know if a stock is low or high? If it’s low, how do you know it will ever go higher? To be more helpful, instead of buy low, sell high, we should say buy stocks that are undervalued and sell stocks that are overvalued. To determine if a stock is under or overvalued, you must first be able to determine the real value of the company.

There are many ways to value a company. You can look at the liquidation value of the company’s assets, its income over the last twelve months, its growth potential, the value of its brand, dividend yields, or the value of similar companies in the same field. To be most accurate, we want to look at some combination of all these things.

What is the Price to Earnings Ratio?

In the first part of this series on how to value a stock, we’ll look at the Price to Earnings Ratio. The price to earnings ratio (P/E) is a measure of the stock price of a company compared to one year’s net earnings per share. If a company has a trailing P/E of 15, then the stock price is equivalent to fifteen times the earnings for the most recent year. In other words, if you bought the entire company and business stayed the same as it was over the last twelve months, it would take you 15 years to recoup your investment (ignoring for the moment the amount of interest or lost opportunity of the initial investment). The P/E reflected in the standard quote data is generally the trailing P/E and may contain the qualifier (ttm) which means the figure given represents the Trailing Twelve Months. The current stock price is used whether we are considering a trailing or a forward P/E.

Forward P/E

Price to earnings can also be calculated based on expected earnings for the next twelve months rather than looking backward at the last twelve months. When using estimates of future earnings, it’s called a forward P/E. Some say this reflects a better estimate of the company’s value since because when you buy a stock, only the amount the amount the company earned last year may not reflect what it expects to earn going forward. On the other hand, a forward P/E is based on estimates of future earnings so it is a less precise measure. I suggest that you look at both. If there is a significant difference between the two ratios, that means something has materially changed in the company’s business between last year and the coming year, or the future estimates are unreasonably optimistic. That would be cause for the investor to drill down and find out what changed, if anything, and whether it’s a one-time event or a more permanent shift in the company’s prospects. Bear in mind that the last year may be the anomaly rather than the current year, so historical perspective should also be considered.

Growth companies, companies which expect strongly rising earnings over the next years, often trade at a higher P/E than more established stable companies because it is expected that the earnings will “catch up to” or surpass the stock valuation in the near term. These companies can also be over-valued due to the irrational exuberance, to borrow a phrase, of those investors trying to latch on to popular issues to avoid being left behind. Never, ever, buy a stock just because everyone says it’s a good investment.

P/E Relative to the Market

Once you have the P/E for a given company, how do you know if the P/E is good or bad? If the average trailing P/E for the all the stocks contained in the S&P 500 is 22.9, our fictional company with a P/E of 15 is trading cheaply relative to the S&P 500. It’s also handy to know whether the S&P 500 itself is currently cheap or over-priced relative to its historic price to earnings ratio as a further point of reference. There are times when the P/E of the market in general, or one specific sector of the market reach very high multiples compared to historical averages. This happened during the dotcom bubble, for example, and should be a strong warning to those considering investing that there is much higher than ordinary risk involved in investing at those levels, regardless of whether one stock compares somewhat favorably to its peers. If they are all overvalued, the relative ranking of any individual issue, does not indicate that it is a good buy.

P/E Relative to Sector

While measuring a company against the overall market provides some guidance, different sectors or industry groups are generally valued differently. A utility company might be very stable but have modest growth expectation and thus trade at a lower P/E than a young and growing tech company, for example. Checking our company’s P/E against an industry average tells us whether it is valued higher or lower than others in the same industry.

 

P/E Relative to Peer Companies

The most accurate comparison will be against peer companies. Peer companies are companies that are in the same business. If our target company is a bank, for example, we would want to compare it to other banks and financial sector companies. The P/E for banks in general might be very different from that of an electric utility company or a young, high-tech firm. We want to make sure we are comparing apples to apples rather than Apple to General Electric.

Price to Earnings Shenanigans

Of course, the published P/E ratio of any given company is only as good as their accounting practices. If a company is misrepresenting its earnings, then the P/E will be misrepresented as well. I won’t go into detail here, but suffice to say, a competent auditor should note any such issues in the audit report, if the company’s financial disclosures have been properly audited. If the P/E seems too good to be true, it probably is too good to be true.

The Weight of P/E in Valuing a Company

The Price to Earnings ratio should not be the only criteria used when evaluating a stock, but it is certainly one of the top five, if not top three most valuable metrics for the prudent investor when viewed in context.