When I look at a stock, the first thing I look at is the P/E ratio. In essence, this tells me how much I will paying for the companies earnings. A P/E ratio of 12 means you would be paying $12 for each dollar of earnings. Now a days the Forward P/E ratio has taken prominence for the most part over the traditional, backwards looking P/E ratio but I think this is misguided. Focusing on only what you think the company will do ignores what the company has already done. So lets delve into the P/E ratio.
Finding the P/E ratio of any company has become very easy over the years because a quick internet search will yield you the answer. But you can also do the calculation on your own. It is very easy to do. Lets take a well know company, Amazon, and figure out what their P/E ratio is. Their earnings per share (EPS) for the last 12 months is 4.02 and their stock price as of today is 837.31.
837.31 / 4.02 = 208.286
So their P/E ratio would be 208, a really high number. Next year, the estimate for EPS is 10.50 so at today’s stock price you would have a Forward P/E of 79. Many things could happen to change the future EPS estimate and that is why I prefer to focus more on the trialing number. If you were to ask me, one dollar today is better than hoping for two dollars tomorrow. Let’s take a second example of another well known company, Walmart
The EPS for Walmart over the past 12 months was 4.34 and their current stock price is 72.12. So their P/E ratio is 16.617, much lower than Amazon. The estimate for next years EPS is 4.47 so at today’s price the P/E ratio would be 16.134. Both numbers are much lower than Amazon showing that if you look at nothing else but the P/E ratio, Walmart earnings are cheaper per share than Amazon.
So you might be asking, why do I care if I won’t be buying individual stocks. It is true that most people buy baskets of investments these days in the form of mutual funds and ETFs but knowing what the P/E ratio is important. For example, you can actually find the P/E ratio of iShares ETFs by looking at their fact sheet. As of 6/30/16 the P/E ratio of their S&P 500 ETF, IVV, was 19.34. In the life of the S&P 500, the P/E ratio has floated around 16. So as you can see, the index is currently over priced based off past history. To me this is good to know because you would be overpaying for companies current earnings. This leads me into my another point.
The P/E ratio has been mentioned in the news a lot lately. Usually you will hear about it in the form of predictions that the markets are ready for a pull back. A recent article on Fox Business stated that the average P/E ratio of S&P 500 companies is sitting at 24, which 50% higher than historical averages. This has lead many to believe that the markets can’t go any higher and a pull back is not only inevitable but it is now a question of when, not if. But there is another side to this coin. If profits start to rise faster than stock prices, the P/E will come down without a market decline. That is one of the inherent dangers of the P/E ratio. You can try to predict market downturns but an economic boom could accomplish the same thing.
So I hope this information has helped you to better understand your investments as well as understand all of the recent news articles about P/E ratios. It is a super simple formula that can help you make better investments. But it can also be dangerous if your trying to predict future market activity and you also have to remember that a companies P/E might be low for a reason. If the fundamentals of the company are on shaky ground and investors start to dump the stock in droves, the P/E ratio will decline. But in this instance it isn’t a good thing. As with any stock analysis tool, it can’t be used in a vacuum but it is still an incredibly powerful tool if used correctly.