How do I interpret a company's price-to-earnings (PE) ratio?

Just about all investment websites will quote a company's P/E ratio. But what does it actually mean and how can you use it when choosing the next stock to add to your portfolio? 

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The price to earnings multiple – more typically referred to as a share's P/E ratio – is probably the most popular and easily available financial ratio. It is simply a company's price per share divided by its earnings per share (or EPS).

Just about every investment website will quote some form of the P/E ratio – but what does it actually tell you about a company's shares? 

The most straightforward interpretation of a company's P/E ratio is that it tells you how much investors are willing to pay in return for $1 of a company's earnings. Although this begs the obvious question: why would investors be willing to pay more than $1 in exchange for $1 of a company's earnings?

Companies like Nextdc Ltd (ASX: NXT) or Nanosonics Ltd (ASX: NAN) regularly trade at multiples of over 150x earnings (or at a price of $150 per $1 of earnings). What would motivate investors to pay so much in return for so little? 

The key to understanding this phenomenon is that the P/E ratio is quoted based on current earnings.

But when you buy a share in a company, what you are really buying are the rights to a portion of that company's future earnings over the lifetime of your investment – which could be decades.

If you are bullish on a company's earnings outlook you would naturally pay more than its current earnings are worth because you anticipate that those earnings will grow exponentially over the period of your investment. In other words, you're willing to pay a higher amount now based on your theory that you'll get much more back through dividends or capital appreciation in the future. 

If many people share your sentiment about a company's future earnings prospects, this will drive both its share price and its P/E ratio higher.

This is why growth stocks like Nextdc have such high P/E ratios. Something unique about their product offering, or business model, or the industry that they operate in leads investors to believe that they will deliver far higher earnings in the future.  

But it's important to note that not every company achieves its potential, and these forecasted earnings are as yet unrealised – they are simply market expectations – and if present circumstances change those expectations can also quickly change. 

A company's P/E ratio will fall when either its share price falls (perhaps because it's not living up to the hype), or its earnings fail to catch up with market expectations and the company enters its more mature stages – maybe even becoming a blue chip. 

So how do you actually use a P/E ratio? It's quite simple conceptually, but can be subjective in practice, which is where it gets tricky.

Essentially you just have to work out whether you think, based on a company's current share price, you're getting a good deal on its future earnings. But how do you know what a good deal is? 

When answering that question, the most important thing to keep in mind is that the P/E ratio is a relative valuation metric. These metrics include price to book or price to sales multiples, and are often also referred to as comparables.

This is because they don't really tell you much about the intrinsic value of a company's shares – they only really mean anything when compared to the ratios of other companies.  

As an example, take a look at some of the leading healthcare stocks on the ASX.

ResMed Inc (ASX: RMD) currently has a P/E ratio of 38, CSL Limited (ASX: CSL) has a P/E ratio of 45 and Cochlear Limited (ASX: COH) has a P/E ratio of 51. So how do we interpret this?  Is ResMed cheap and Cochlear expensive? Which share should you buy? 

This is where that subjective element comes in – perhaps Cochlear's higher P/E ratio is warranted because its products are so differentiated from its competitors that it will outperform in future. Or maybe ResMed, with its lower P/E ratio, is being overlooked by investors and you should snap it up on the relative cheap. 

Foolish takeaway

Either way, to properly interpret a company's P/E ratio requires that you spend the time to research the company's products, business model, and the industry in which it operates. But, when used properly, the P/E ratio can still be an invaluable tool in your stock selection process.  

Motley Fool contributor Rhys Brock owns shares of Cochlear Ltd. The Motley Fool Australia owns shares of and has recommended Nanosonics Limited. The Motley Fool Australia has recommended Cochlear Ltd. and ResMed Inc. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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