What Is a Good P/E Ratio for Stocks?

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The price-to-earnings ratio is one of the most well-known fundamental metrics that is being used when analyzing the value of a stock. It essentially indicates how much a company is earning in relation to its current market price. The P/E of a stock is calculated by dividing the current stock price with the stock’s earnings-per-share (EPS).

Generally speaking, the lower the p/e of a stock the better since you are essentially paying less dollars for the earnings of a company.

There is a simple way to depict the P/E ratio that may help you get a better understanding of the price multiple: The P/E of a stock is the price, which you have to pay for, to obtain 1 dollar as earnings of the business.

Let’s assume you had to choose between business A that has a P/E ratio of 10 and business B, which has a P/E of 30. From a pure valuation perspective based on the P/E, it would be logical to invest in business A, as you are only paying 10 dollars to receive 1 dollar as earnings, while business B would cost you 30 dollars to receive the same 1 dollar as earnings.

That being said, using the P/E ratio in practice and only making investment decisions based on P/E isn’t that simple. Just because a stock may have a lower P/E ratio than another, it doesn’t necessarily mean that it’s going to perform better in the future. Everyone would just look for companies trading at the lowest price-to-earnings ratio and buy them if things were that easy.

There are a few things to take into consideration when using the P/E ratio.


Using the P/E Ratio

At the stock market, there is a wide range of companies trading at a price-to-earnings ratio from below 1, to stocks that hold a P/E multiple within the hundreds. It would be extremely vague to say that those stocks, that have the lowest p/e are better investments than those that are trading at the highest P/E ratios.


Therefore, it is pretty obvious that making an investment decision based only on the P/E can be difficult because just the P/E multiple on its own, won’t tell anything about the future performance of a business.

If the price-to-earnings ratio on its own isn’t enough to make investment decisions, how should you use the price multiple instead?

One approach would be to compare the price-to-earnings ratio of different companies within the same industry with each other. Businesses that are operating within the same industry usually have similar characteristics and have to deal with the same market conditions. Different industries typically have different P/E ranges, where each business in that industry usually is traded in that P/E ratio level.

You could additionally compare the P/E ratio of a stock with the average price multiple of it’s operating industry. This would give you a quick glance at how the company is currently valued in relation to the average business in its industry.

Sometimes the overall p/e ratio of an industry can rise far above the historical average. This could indicate that the whole market sector or industry is overpriced. Conversely, the same can happen when industries become undervalued and the average p/e ratio is much less than the historical average price multiple.


What the P/E Ratio Tells About a Company

The P/E ratio can be an indicator that could tell if a company is either under or overvalued. However, there is oftentimes a reason why a stock may be traded at a low price. The P/E ratio is defined by the current earnings and the current market price of a company. And the current earnings on its own can’t tell how the stock is actually going to perform in the future. This is why you should rather use other valuation metrics in addition to the P/E to get more insights into the financial well being of a company.

What it can potentially tell you is how investors are currently expecting the company to perform in the future, which is projected in the current market price of the stock. A high P/E ratio may indicate that investors are willing to pay more for the business because of its future potential. The stock market consists of many different types of companies from several industries. One business might have the potential to grow much faster than other businesses. Stocks that are expected to grow rapidly are also defined as growth stocks and are usually priced at a higher P/E than other stocks.

For instance, when a business is likely to grow massively, expectations are also going to rise, which may result in an increased demand for its stock and therefore, a higher P/E.

If we take a look at the P/E of Amazon (AMZN) and Facebook (FB) you can see that those companies are trading at very different P/E levels. In late 2019, Amazon is currently trading at a P/E ratio of 74, while Facebook at a P/E of 32. One of the main reasons why Amazon is traded at a higher multiple is the fact that investors see a higher growth potential for the stock in the near future. And this is why they are willing to pay more despite the fact that the stock might be overpriced.

However, does this mean that Amazon would be a better investment than Facebook? It would be risky to answer such a question just by the current P/E multiple of a stock. You would need to dive a lot more into the details of both companies to actually answer this question for yourself. The price-to-earnings ratio can only give you a vague view of the valuation of a stock and may also reflect the current expectations by the market.


Conclusion

Just because a stock seems cheap in relation to its earnings, it doesn’t mean that you should buy it. Your investment decision should never exclusively rely on the P/E ratio. That being said, a lower price-to-earnings multiple may indicate that a company is undervalued, especially when you compare it with other P/Es of other companies within the same industry.

Companies with high P/E ratios usually have high expectations and it’s stock price tends to be very sensitive if it doesn’t meet investor’s expectations. Therefore, investing in high P/E stocks oftentimes comes with a higher amount of risk for you as an investor

In the end, it all comes down to the question of what type of investor you prefer to be. There are many conservative investors, who would never buy stocks trading at a P/E ratio of above 30. On the other side, many investors are actually looking for businesses with high P/Es with the hope that those businesses are going to grow rapidly in the near future.

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Disclaimer

The information on this website is not intended as investment advice. Do not consider the information as individualized financial advice or advocation to buy and sell any finanical securities. 

Investing comes with inherit risks. Therefore, you should always consider seeking investment advice from a professional who is aware of your individual financial situation. You are responsible for your own investment research and decisions.

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