How to Evaluate Price-to-Earnings Ratios as a Stock Investor - dummies

How to Evaluate Price-to-Earnings Ratios as a Stock Investor

By Paul Mladjenovic

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.