“What is P/E ratio, or price to earnings ratio?”
We hear this question a lot from people who are in the early stages of learning about investing. It’s a perfectly valid question, so we put it to members of our investing team to discuss.
RYAN: Scott, what is a price to earnings or P/E ratio as it’s often referred to?
SCOTT: Yeah, one of the terms that’s thrown around so much in investing, and it’s really worth trying to understand. So let’s break it down. Price to earnings is funnily enough exactly what it says on the tin. Price, price per share. Earnings, earnings per share. If I’m paying $20 for a share, and I’m getting $1 in earnings, 20 divided by one is a P/E of 20, or 20 times earnings. It’s a measure of how expensive or cheap that company is, relative to the number of earnings you’re getting. Now, if I can buy a company for 10 times earnings, if I pay $10 for a dollar earnings, I’d rather take that than paying $20 for that same dollar of earnings. The cheaper I get the shares for, relative to earnings, the better a deal I’m getting. Now, that doesn’t mean cheaper as in price per share because a $20 company with $1 earnings is 20 times, a $10 stock feels cheaper, but if there’s no profit at all, well, guess what? I’m getting a worse deal than if I buy this company that’s a P/E of 20. Now, it’s not necessarily the be all and end all the most important thing here is there’s companies with no, Amazon a great example, right? Multi billion, one of the top five, most valuable companies in the world has almost not got a P/E at all. And so there’s, we really be very careful and saying you should only buy low P/E stocks, which is a value investing approach that can work for some people, it’s not the only way to invest, though, but it’s designed to give you a look across the market and say, all right, what are the more expensive and the cheapest stocks? At least based on that one base of the earnings itself from the company. So if I got two companies side by side, one’s at a P/E of 20, that’s more expensive, all things being equal, than a company with a P/E of 10, which is more expensive than a P/E of five and so on.
RYAN: Okay, and what, one other thing as well is we often hear trailing P/E or forward P/E, what’s the difference?
SCOTT: Yeah, all right. So the trailing applies not to the price, coz the price is always today’s price, but the earnings. So you can, you can look to a P/E based on last year’s earnings, or your expectation of next year’s earnings and get two very different numbers. So the same company I talked about $20 a share, earnings of $1 last year. Trailing P/E of 20, that is 20 times last year’s earnings. If that is going to double next year, the forward P/E or the forward earnings, also that P/E drops from a trailing P/E of 20, to a forward P/E of 10 coz 20 divided by two in this case when the earnings double is a P/E of 10. And again, that’s why, assuming the expensive company based on last year’s numbers can all of a sudden look pretty cheap based on next year’s numbers. As long as those earnings come in, there’s always doubt, always uncertainty there, so be a little bit careful with forward P/Es because they can be dressed up based on over-optimistic expectation. But it’s always worth, as with any investing, looking forwards, not backwards.
RYAN: So the low P/E doesn’t necessarily mean you’re getting a bargain?
SCOTT: Correct. In fact, some of the worst investment ever have been low P/E stocks, either like they’ve gone broke or continue to do really, really badly. Some of the best companies over time have had really high P/Es and kept on delivering even more. Also though the reverse is also not necessarily true, buying every expensive P/E company doesn’t guarantee you a good return. As always, we should buy carefully and buy thoughtfully, the P/E is one tool in that toolkit.
RYAN: Okay, so we shouldn’t, I guess, rely on our entire investment thesis on the price to earnings ratio. More you use it as a guidance or a screening tool almost.
SCOTT: Perfectly put.
RYAN: Excellent, thanks, Scott.
SCOTT: Thanks, Ryan.