The PE ratio is one of the most common and important metrics involved in stock market analysis. The PE ratio gives investors some indicator of valuation or how expensive a stock might be at a given point in time. But what is a good PE ratio? What is the range of PE ratios that warrants buying the stock? It’s a trickier answer than you might suspect because of all the variables and some of the limitations with the PE ratio itself. In this article, we’ll consider what is a good PE ratio along with discussions of the imitations of the PE ratio and some alternative valuation metrics.
As we begin, let’s first break down what exactly the PE ratio is. To get the PE ratio, you need to know the earnings per share (EPS) of the stock. Once you have the EPS, you can calculate the PE ratio by looking at PE ratio = Share Price / EPS. Let’s look at a simple example.
If company ABC has $4.00 in earnings per share and its stock is trading at $40 per share, then you know the PE ratio is 10 since $40 / $4 = 10.
Some investors view the PE ratio as a way to consider how many years of earnings you’ll need the company to generate in order to justify paying the current share price for the stock. In the previous example, since the PE is 10, you’re essentially buying the company at 10 times earnings. The PE ratio is basically the multiple of earnings you’re willing to pay for the stock.
In the traditional sense, the PE ratio is backward looking since it often uses EPS values that are reported from the company for the previous quarter or year. Sometimes, analysts and investors want to know how expensive a stock is based on future earnings. Investors want to know the multiple they are paying against future earnings. Future earnings can be deduced based on company guidance and Wall Street analyst estimates. They are potentially more useful in that it gives investors an indication for what multiple they are paying against forward looking earnings, but they are prone to inaccuracies since they are merely estimates.
While PE ratios are used for both backward looking and forward looking earnings, typically the forward looking PE ratio is qualified as “forward looking.” If there is no qualification, and someone references the straight forward “PE ratio,” then you should infer that they’re referencing the price to earnings ratio of backward looking earnings.
If you’re truly a beginner in the stock market, the share price of a stock does nothing to tell you how expensive the stock is. Share price is affected by the number of shares outstanding. If two companies are both worth $1 billion (market cap), but the first company has 1 million shares outstanding and the second company has 10 million shares outstanding, then the first company will have a share price of $1000 and the second company will have a share price of $100. Which company is more expensive? You don’t have enough information to answer the question. Share price doesn’t tell us anything with respect to valuation. The PE ratio is one of a number of tools to gain insight into valuation.
At a glance, the PE ratio tells you how expensive a stock is, and investors often use this valuation metric as part of the decision making process on whether or not to buy the stock. But once again, what is a good PE ratio when considering whether or not to invest in the stock?
While at a surface, it might seem simple to compare valuation across various stocks using the PE ratio, determine the least expensive stock and then buy the cheaper stocks. After all, who wants to buy “expensive” stocks? But it’s not this simple. PE ratio can be affected by the industry or sector that a company operates in, but more than anything, the PE ratio is affected by how fast a company is growing.
Simply put, investors are willing to pay more for a company that is growing faster. It makes sense, right? If you know a company is growing quickly, you’ll pay a higher multiple of current earnings than you would pay for a company that is hardly growing earnings at all. We know this intuitively, but it’s interesting how this simple concept is often forgotten when investors are talking about the stock market.
We’ll discuss limitations of the PE ratio and how growth is such a big factor later on in this article, but for now just know that if you’re using PE ratio to compare stocks, make sure that you keep PE ratio in its proper context. Or, you might just make sure when doing PE ratio comparisons that the other metrics of the stocks are relatively equal. If two companies are in the same sector and have similar growth rates, then comparing PE ratios might be a good way to determine what the better buy is.
Limitations of the PE ratio
One of the main limitations of the PE ratio is the “quality” of the earnings. When asking what is a good PE ratio, we need to have assurances that the earnings per share (EPS) within the PE ratio are truly real earnings. Sometimes earnings can be impacted by unusual or one-off gains or losses or other accounting mechanisms such as depreciation. Or, at times, expenses might be recognized over time in some sort of amortization even though the company has already spent the money on a particular expense (hence why analysts like to look at cash flow statements as well as the income statement). So, earnings are, well, complicated.
When analyzing a company and its PE ratio, you need to be sure you have a firm grasp of how the company is reporting its earnings. Accounting can be tricky, and just because a company is utilizing common accounting measures that makes measuring earnings more difficult, it doesn’t mean that the company is being shady or fraudulent. It just means you have to work harder as an investor or analyst to gain the full picture and truly understand the valuation of a particular company.
The biggest limitation of the PE ratio, as we discussed already, is the fact that PE ratio doesn’t tell you much about the company’s ability to grow revenues and earnings in the future. If you just look at the PE ratio by itself, you might quickly determine that a company trading at a 80 multiple against earnings is super expensive and that a company trading at 8 times earnings is very cheap. And you can be wrong in both scenarios. If the company with the 80 multiple is doubling revenue every year, that company might be trading pretty cheap, and the company trading at an 8 multiple might be shrinking and therefore actually be expensive. Again, you can’t look at nothing but the simple PE ratio and make a call on the stocks.
Using the PEG alternative
Some investors attempt to use the PE ratio alternative of the PEG ratio in order to attempt to address the PE ratio limitations around growth. The PEG builds upon the PE ratio, adds in growth estimates to give an indicator of how expensive a stock might be while also factoring in growth rates. Here’s how this is accomplished:
So, a stock with a PE ratio of 15 that is growing earnings at a 15% growth rate will have a PEG of 1. If a stock has a PE ratio of 15 and is growing earnings at a 25% growth rate, it will have a PEG of .6. Finally, a stock that has a PE ratio of 15 and is growing earnings at a 10% growth rate will have a PEG of 1.5.
So, we can take away from this that when PEG goes over 1, you’re starting to pay more for growth. When the PEG is under 1, you’re getting growth for a less expensive valuation. In general, we want a low PEG when buying a stock.
Of course the PEG option is still bound by limitations around the quality of earnings factored into the PE ratio and the quality of the earnings growth estimates which can have accuracy issues. Like the PE ratio, the PEG can be one of many tools in your fundamental analysis toolbox.
What about debt?
While growth is typically most commonly cited as a limitation of the PE ratio, it’s worth making a few notes about debt as well. When answering the question of what is a good PE ratio, ignoring debt can be a mistake.
The PE ratio does not tell you anything about a company’s debt position. Debt levels can impact a company’s financial performance, yet the PE ratio doesn’t indicate whether a company is debt free or bogged down by heavy debt loads.
Another alternative way to attempt to factor in debt into the equation is to utilize enterprise value (EV) instead of share price. Enterprise value is typically used to replace market capitalization of a company when analysts want to factor in cash and debt levels on the balance sheet. To calculate enterprise value, we use the following equation: EV = market capitalization + debt – cash.
At first glance, you might be wondering why the EV equation adds debt to market capitalization. Shouldn’t we be subtracting debt since we want an estimate of the value of the company? The reason debt is added (and cash subtracted) is that enterprise value is considered to be essentially a takeover price if the company were to be bought by another party. The value of the company’s debt, for instance, would have to be paid off by the buyer. Thus it adds debt to the overall calculation.
To demonstrate, here is a quick example. If a company with a market capitalization of $100 billion, $30 billion in debt and $5 billion in cash is being considered as an acquisition target, the enterprise value of the company would be $125 billion. The acquiring company essentially needs $125 billion in funds to make the acquisition since it would need $100 billion to buy out the market capitalization of the company and another $25 billion to pay off the debt that comes with the company (while using the $5 billion in cash).
Let’s get back to using EV as an alternative way to do the PE ratio. If a company’s shares are trading at $10 per share, has $2 per share of net debt and earnings of $2, then the traditional PE ratio would be 5 ($10 / $2). Another way of attempting to value the company is to use EV in place of share price and EBITDA in place of earnings. EBITDA, of course, is different from earnings as it adds back in interest, taxes, depreciation and amortization costs to earnings.
Interesting PE Ratio examples
I recently had a debate with a friend over whether Disney (DIS) or Netflix (NFLX) would be the better investment over the next five years. You can make a great case for either stock, but I pushed back when my friend brought up the PE ratio. He said to me, “Netflix is twice as expensive as Disney.” This statement was based on the simple fact that the PE ratio of Netflix was about 80 and the Disney PE ratio was about 40. To me, that PE ratio is completely irrelevant. To my friend, he believes there’s a straight-forward answer to the question of what is a good PE ratio?
Netflix is one of my favorite examples of why I rarely look at PE ratio when comparing stocks. Netflix is a great example of a company that is playing the long game. Revenue growth is much more of an emphasis for the company than earnings. Netflix funnels essentially all of its cash from operations (as well as some cash from debt issuance) back into the company to fuel revenue growth.
As Netflix delivers increasing amounts of revenue and subscriber growth, the stock has continued to move higher. Meanwhile, earnings have been pretty much flat and even random bumps in earnings from quarter-to-quarter are fairly meaningless. For instance, during the 2020 quarter where coronavirus ended up in major shutdowns of television production, Netflix saw a huge boost in subscribers while also had a large drop in expenses. The expenses didn’t necessarily decrease, they just got moved back to further in the year when production could resume. But this led to a big jump in earnings for this quarter. This also led to a decrease in the PE ratio. However, using this move in the PE ratio to justify an investment in the stock seems silly.
As you can see in the above chart, Netflix’s PE ratio has been anywhere from 75 to 450 over the last 6+ years. Go ask friends that are familiar with the stock market the question of what is a good PE ratio for a stock you’re considering buying. I’d wager that none of them would say a number anywhere close to what Netflix has been trading at in recent years. In fact, if you were to purchase Netflix in March of 2013 when its PE ratio was around 450, you would have purchased the stock at around $23 per share (adjusted for splits). Your return as of end of March 2020, 7 years later, would have been almost 14x your investment with shares trading around $370.
Similarly, if a low PE ratio is a requirement for owning a stock, you would have likely never bought Amazon (AMZN). Amazon of course is one of the world’s highest performing companies now for well over a decade and has grown to incredible valuations as it continues to grow.
There’s a simple take-away here. Sometimes, PE ratio will show you that a stock is overpriced and too expensive. However, if you never buy a stock that has a high PE ratio, in all likelihood, you’ll never own a stock that is a fast growing stock. This doesn’t mean you should go out and find a bunch of high PE ratio stocks and fill your portfolio with them. That’s definitely not the take-away.
If, however, you are sure of the future of a company and its ability to grow revenues many times over and lead to immense profitability down the road, letting a high PE ratio deter you from owning the stock is a mistake. Finding such companies, of course, is easier said than done.
The beauty of investing is that you can pick the style of investing that suits your risk profile and your own preferences. If you use strict PE ratio levels to guide some of your investment decisions, that’s a perfectly reasonable approach. Just know what that means going into it. In you only purchased stocks with low PE ratios, then you’re likely going to only be owning companies that are very mature companies with high levels of earnings and cash flow and limited growth prospects. There’s nothing wrong with this approach.
PE ratio as an overall market valuation metric
Since it is possible to consider the combined earnings (and share price) of a group of stocks, it’s also possible to consider the combined PE ratio of a group of stocks. Tracking the PE ratio of, say, the S&P 500 stocks can be a useful metric for analyzing how expensive the overall stock market might be at a given point in time.
The CAPE ratio is a popular indicator of doing exactly this. The CAPE ratio (which stands for Cyclically Adjusted PE ratio) was created by a man named Robert Shiller and seeks to value the overall market using a modified version of the typical PE ratio formula. The CAPE ratio is calculated by taking share price divided by the 10-year average of inflation-adjusted earnings. CAPE uses a 10 year average in order to attempt to smooth out fluctuations in corporate earnings.
While the CAPE ratio (and other similar market valuation techniques) can be informative, many investors are skeptical that the CAPE ratio is an actionable indicator. For instance, in recent years of the low interest rate environment, the CAPE ratio has been very high historically. However, if you were to sell stocks as a result of a high CAPE ratio, you would have essentially lost out on immense gains in the stock market. Like most valuation metrics, they are one of many indicators that should not be used in isolation as a determining factor of various investment actions.
To sum up this PE ratio discussion, let’s go back to the original question: What is a good PE ratio? The reality is that the answer is not an objective one, but more of a subjective one. There does not exist a formula in investing where if you buy stocks at a certain PE ratio, it will result in a specific amount of return. Instead, the PE ratio is more about suiting your own investing style and philosophy.
As you analyze stocks to purchase for your portfolio, understanding the PE ratio within the context of its industry, its growth rate and its competition definitely makes sense. Moreover, you might consider comparing the PE ratio over time against itself and understand where the current PE ratio falls within the range of historical values for the company. But mostly the PE ratio can serve to ensure you’re buying the types of stocks you’re comfortable buying.