How to Evaluate Price-to-Earnings Ratios as a Stock Investor
When someone refers to a price-to-earnings (P/E) ratio as high or low, you have to ask the question, Compared to what? in order to get a valid evaluation of the stock investment. A P/E of 30 is considered very high for a large cap electric utility but quite reasonable for a small cap, high-technology firm.
Keep in mind that phrases such as large cap and small cap are just a reference to the company’s market value or size. Cap is short for capitalization (the total number of shares of stock outstanding × the share price).
The following basic points can help you evaluate P/E ratios:
Compare a company’s P/E ratio with its industry. Electric utility industry stocks, for example, generally have a P/E that hovers in the 9–14 range. Therefore, an electric utility with a P/E of 45 indicates that something is wrong with that utility.
Compare a company’s P/E with the general market. If you’re looking at a small cap stock on the Nasdaq that has a P/E of 100 but the average P/E for established companies on the Nasdaq is 40, find out why.
You should also compare the stock’s P/E ratio with the P/E ratio for major indexes such as the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 (S&P 500), and the Nasdaq Composite. Stock indexes are useful for getting the big picture.
Compare a company’s current P/E with recent periods (such as this year versus last year). If it currently has a P/E ratio of 20 and it previously had a P/E ratio of 30, you know that either the stock price has declined or that earnings have risen. In this case, the stock is less likely to fall. That bodes well for the stock.
Low P/E ratios aren’t necessarily a sign of a bargain, but if you’re looking at a stock for many other reasons that seem positive (solid sales, strong industry, and so on) and it also has a low P/E, that’s a good sign.
High P/E ratios aren’t necessarily bad, but they do mean that you should investigate further. If a company is weak and the industry is shaky, heed the high P/E as a warning sign. Frequently, a high P/E ratio means that investors have bid up a stock price, anticipating future income. The problem is that if the anticipated income doesn’t materialize, the stock price can fall.
Watch out for a stock that doesn’t have a P/E ratio. In other words, it may have a price (the P), but it doesn’t have earnings (the E). No earnings means no P/E, meaning that you’re better off avoiding the stock. Can you still make money buying a stock with no earnings? You can, but you aren’t investing; you’re speculating.
An individual with net worth of more than $1 million (alone or jointly with a spouse) or with income of $200,000 in each of the past two years and with a reasonable expectation of the same level of income in the current year. Certain higher-risk investments are often restricted to accredited investors.
A risk-adjusted measure of performance. Alpha measures the portion of an investment’s return attributable to the security’s inherent values (for example, earnings growth) rather than to overall market movements.
A trading technique that takes advantage of price discrepancies when the same security, currency, or commodity is traded on different markets.
A condition that is met when an option’s strike price is the same as the prevailing price for the underlying stock. For example, if stock ABC is trading at $125 and the option’s strike price is also $125, then the option is at the money.
A financial statement that shows the value of a company’s assets, liabilities, and owner’s equity on a given date. Total assets minus total liabilities equals owner’s equity.
A situation that occurs when you have sold something you do not own. In commodities, if you enter into a contract to sell a commodity which you don’t own with a promise to deliver it at a set price on a future date, then you are short that commodity. In stocks, you are short a stock if you have sold it and borrowed the shares from a broker to deliver to the purchaser, with an obligation to replace the borrowed shares at a future date. Being short means that you’re bearish, or negative on the market, and that your goal is to make money when the security or commodity that you choose to short falls in price.
A measure of a stock’s relative volatility. A stock with a higher beta can be expected to rise or fall more than the overall market, whereas a stock with a lower beta is less volatile than the overall market.
A theoretical model used to calculate the fair market value of an option based on time to expiration, price of the underlying stock, historical volatility, strike price, and carrying costs.
A contract that gives the holder the right to buy a particular asset at a specified price at any time prior to the expiration of the option.
A bond that the issuer can redeem before its maturity date. The bondholder is often paid a premium when the bond is called.
A chart that shows the daily high, low, opening, and closing prices for a security over a specified time period.
The profit from the sale of an investment at a price that’s higher than the purchase price.
An interest-bearing investment issued by a bank. CDs are typically available with maturities ranging from three months to five years.
Buying and selling securities by a broker for the sole purpose of generating commissions.
A call option written by an investor who already owns the underlying shares. If you write a covered call and the option is exercised by the holder, then you would just deliver the stock to the holder.
Delta represents the price change of an option for every one-point change in the price of the underlying security or futures contract.
A financial instrument whose value is based on the value of another asset or index. A stock option, for example, is a type of derivative that gives you the right, but not the obligation, to buy shares of the stock at a predetermined price. The option’s value changes in relation to the price of the stock.
An electronic order-routing system used by NYSE member firms to send market and limit orders directly to the specialist at the exchange who trades that particular security.
Money paid out by a company to the owner of its stock. An income stock is a stock that has a regularly paid, higher-than-average dividend.
A market in which stock shares are issued and traded. Trading takes place through both exchanges and over-the-counter markets.
A mutual fund that is traded, like stocks, on an exchange.
Currency that a government declares to be legal tender, even though it is not backed by reserves of physical assets (such as gold). The value of fiat money derives solely from the public’s confidence and faith in its ability to serve as a storage medium for purchasing power. Most of the world’s money is fiat money.
The largest non-governmental regulatory organization responsible for overseeing all securities firms that do business in the United States. Responsibilities include professional training, testing and licensing of registered representatives, and arbitration and mediation.
Speculation on the value of one currency versus another, in which you buy one country’s currency—just as you’d buy a stock or other security—in the hope that it will appreciate relative to the value of another currency.
Contracts where you agree to buy or sell a specific amount of a commodity, currency, or other asset at a specified price on a specified future date. Unlike an option, a futures contract creates an obligation, rather than just a right, to buy and sell the underlying security.
When you own a security or other asset, you are said to be long that security. When you go long (that is, buy) a security, you’re bullish, or positive on the market, and you expect the price of that security to go up.
Privately held corporations created by Congress to work for the common good—generally to facilitate borrowing for homeowners, farmers, and other specific groups. Examples of GSEs include Fannie Mae, Freddie Mac, and the Federal Farm Credit Bank.
A chart formation in a graph of an asset price that resembles three mountaintops in a row, with the middle mountaintop being taller than the other two. The pattern indicates a trend reversal, meaning that prices are expected to fall.
An investment strategy that allows you to reduce the risk of an unfavorable price change in a security or commodity. For example, a stockholder of ABC Company who is worried about declining stock prices can offset that risk by buying a put option on ABC, allowing him to sell his shares in the future at today’s price.
Investments that don’t trade very actively and are difficult to sell on short notice.
A theoretical value representing the volatility of the security underlying an option. Implied volatility is used by the Black-Scholes model, among others, to calculate the price of an option. Implied volatility usually rises when the markets are in downtrends, and falls when the markets are in uptrends.
A condition that is met when a call option’s strike price is below the prevailing price for the underlying stock. For example, if stock ABC is trading at $125 and the option’s strike price is $120, then the option is in the money. For a put option, the strike price must be above the current market price of the stock for the option to be in the money.
A mutual fund designed to mirror the performance of a specific market index such as the Dow Jones Industrial Average or the S&P 500. Expenses of index funds tend to be lower than other mutual funds because the manager is not actively researching, buying, and selling securities.
A type of individual retirement savings plan. There are several types of IRAs, including, among others, Traditional IRAs and Roth IRAs. Traditional IRAs are tax-deferred accounts that currently allow individuals to contribute up to $5,000 per year. Contributions to a Traditional IRA may be tax deductible, depending upon several factors. You don’t pay taxes on the income and gains you generate in a Traditional IRA until you make withdrawals; all withdrawals will be taxed at the ordinary income tax rate. Roth IRAs are subject to different tax treatment.
The degree to which an investor or business is utilizing borrowed money. For investors, leverage is a means of multiplying the return on an investment by borrowing money to purchase additional securities or other assets. Buying securities on margin is an example. If you have $1,000 of cash and borrow another $1,000 from your brokerage, you could then purchase $2,000 of stock. If the value of the purchased stock increases by 10 percent ($200), then you have realized a 20 percent gain ($200/$1,000) on your actual cash investment.
The value of a company as measured by the total number of stock shares outstanding times the market price of each share. For example, if company ABC has 20 million shares outstanding, and each share is currently worth $100, then the market cap for ABC is $2 billion. In general, stocks are classified as large cap (over $5 billion), small cap (under $1 billion), or mid cap (anything in between).
A stock index where the effect of each stock on the index is in proportion to its market value.
A major ongoing development that is expected to have significant implications for most (if not all) facets of society over an extended period of time. The aging of the American population is an example.
The perceived strength behind a price or volume movement in a security based on the rate of acceleration of that movement.
In technical analysis, a chart line that shows the average of a security’s price over a specified period of time, recalculated for each new data point. For example, a 30-day moving average will include yesterday’s price and those for the previous 29 days. Tomorrow’s moving average will include today’s price but will drop the price for the earliest date in yesterday’s average. The moving average is used to spot pricing trends by flattening out large fluctuations.
A bond issued by a local or state government or agency. Munis generally raise money for public projects such as hospitals, roads, bridges, and sewer systems as well as general governmental operations. When you buy a muni, the interest is usually exempt from federal income tax.
A fund operated by an investment company that raises money from shareholders and invests that money in a group of assets in accordance with one or more stated objectives, such as income, growth, aggressive growth, and so on. A mutual fund may generally invest in stocks, bonds, options, futures, currencies, and money market securities in accordance with its stated parameters. All shareholders share equally in the income, gains, and losses generated by the fund.
A call option written by an investor who does not already own the underlying shares. If you write a naked call and the option is exercised by the holder, then you would have to buy the stock at the market price to meet your obligation. Naked calls are very risky, though potentially very rewarding.
An electronic stock exchange established by the National Association of Securities Dealers (NASD). The Nasdaq lists over 3,200 companies and is the largest equity securities trading market in the U.S.
A system where traders on a trading floor or in a trading pit shout and use hand signals to make transactions or trades with each other.
A derivative security that gives the holder a contractual right to buy or sell a set amount of a stock, commodity, or other asset at a specified price on or before the option’s expiration date. An option is purchased for a fee, called a premium.
A person who is buying options. Call option holders have the right to buy a stipulated quantity of the underlying asset specified in the contract at a specified strike price. Put option holders have the right to sell the specified amount at the strike price.
A condition that is met when a call option’s strike price is above the prevailing price for the underlying stock. For example, if stock ABC is trading at $120 and the option’s strike price is $125, then the option is out of the money. For a put option, if the strike price is below the current market price of the stock, then the option is out of the money.
A securities market where trades are conducted by phone or computer network directly between dealers rather than on a physical trading floor. All bonds trade over-the-counter, as do unlisted stocks (generally, stocks of smaller companies that do not qualify for listing on an exchange).
A contract that gives the holder the right to sell a particular asset at a specified price at any time prior to the expiration of the option.
A company, usually traded publicly, that raises money from shareholders and invests that money in a portfolio of real estate properties. REITs are modeled after mutual funds, although the tax treatment of REIT income is different.
A statistical technique used to find the mathematical relationship between a dependent variable (such as a company’s stock price) and one or more independent variables (such as GDP, income growth, or inflation). Regression analysis is used to predict future values of the dependent variable based on changes in the independent variables.
A price movement in the opposite direction of the previous trend. When a price has gone too far and traders deem the security overbought or oversold, the price may stop rising or falling and move in the opposite direction for a period of time.
A type of IRA in which contributions to the account are not tax-deductible, but qualified withdrawals are completely exempt from federal income tax.
A federal agency whose mission is to protect investors from fraud or other unlawful market activities.
A nonprofit corporation created by Congress in 1970 to protect investors in the United States. SIPC insures the assets in investor accounts (up to certain maximum amounts) at registered brokerage firms in the event of bankruptcy of those firms.
An instruction to a broker to sell a stock at the market price after the security has touched the specified stop price. A sell stop is always placed below the present market price and is usually designed to protect a profit or limit a loss.
The general feeling among investors as to which direction the stock market is heading. If the sentiment is that prices are going up, it is said to be bullish; if the sentiment is toward a downward movement, it is bearish. Investors base sentiment on market activity and movements in the prices of securities.
A situation that occurs when you have sold something you do not own. In commodities, if you enter into a contract to sell a commodity which you don’t own with a promise to deliver it at a set price on a future date, then you are short that commodity. In stocks, you are short a stock if you have sold it and borrowed the shares from a broker to deliver to the purchaser, with an obligation to replace the borrowed shares at a future date. Being short means that you’re bearish, or negative on the market, and that your goal is to make money when the price of the security or commodity that you choose to short falls in price.
A retirement plan available to small employers and self-employed individuals in which both the employer and employee can contribute to an IRA.
An annuity contract that you purchase from an insurance company with a single upfront payment. An SPIA usually starts making regular monthly payments to you immediately.
You create a straddle when you simultaneously buy a put and a call on the same stock at the same strike price and with the same expiration date.
You build a strangle when you buy a put and a call on the same stock with the same expiration date but at strike prices that are equally out of the money. A strangle costs less than a straddle because both options are out of the money, but you only make a profit if the price of the underlying stock moves dramatically.
The price at which the stock or commodity underlying an option can be purchased (call option) or sold (put option) pursuant to the terms of the contract.
An exchange of streams of payments over time according to specified terms. The most common type is an interest rate swap, in which one party agrees to pay a fixed interest rate on a notional principal amount in return for receiving an adjustable rate from another party.
One-sixteenth of a point.
A price change in a security’s trades. If the next trade takes a security up in price, it’s an uptick; if it takes the security down, it’s a downtick. In futures and options trading, a tick is the minimum change in price, up or down.
The spread between the high and low prices of a security or commodity within a particular period.
Debt obligations of the U.S. government that are secured by its full faith and credit. Treasuries include bills (maturities of less than one year), notes (maturities of 1 to 10 years), and bonds (maturities of more than 10 years).
A statistical measure of the movement of a financial asset's price over time, gauging how fast the price of the asset changes. The price of a highly volatile security can change dramatically over a short period of time. A measure of the volatility of a security relative to the overall market is its beta.
A person who is selling options. Call option writers have the obligation to sell a stipulated quantity of the underlying asset specified in the contract at the specified strike price if the option is exercised by the holder. Put option writers have the obligation to buy the specified amount at the strike price if the option is exercised.