Price-to-earnings ratios (P/E) are valuation ratios of a stocks’ current share price divided by its per share earnings. The earnings could be last year’s, making it a 12-month trailing P/E, or projected earnings, making it a forward P/E. Sometimes it is a combination of six months trailing and six months projected earnings. At Henssler Financial, we prefer to use a forward P/E, because the stock market is forward looking, as stocks are traded on what investors’ think will happen next to a stock’s price.
If you have two stocks, one priced at $100 and one priced at $50 per share, which stock is cheaper? Without looking at the stocks’ P/E, you do not actually know. The $100 stock may have $10 in earnings per share, giving it a P/E of 10, while the $50 stock only has $4 in earnings per share, giving it a P/E of 12.5. In this case, the $100 per share stock is the cheaper buy, as it is earning more per share.
The first question that should be asked after seeing this analysis is “Is this a good P/E or a bad P/E?” The answer, in typical finance fashion, is “it depends.” Despite the relative simplicity in deriving a P/E, its application can be quite complicated. Several factors must be considered. Ideally, one should prefer to find a stock with a P/E ratio that is equal to, or below, the projected growth rate. The price-to-earnings-to-growth (PEG) ratio is used to determine a stock’s value, while taking the company’s earnings growth into account. Often this provides a more complete picture than the P/E alone.
You also have to look at the stock in relation to its industry. Consider Automatic Data Processing (NASDAQ: ADP) and Paychex Inc. (NASDAQ: PAYX). ADP has a lower P/E than Paychex, but if Paychex is growing earnings faster the higher P/E may be justified. You also have to consider the quality of earnings. Does the company consistently hit its projections?
Often stocks with lower P/Es are considered value stocks, while stocks with higher P/Es are considered growth. You also should consider, however, the cyclical nature of the stock. With cyclical companies, an investor should want to buy when the P/E is high. As the stock comes into favor, earnings start to grow and the stock price should then rise, bringing its P/E lower. But because it is a cyclical stock, the earnings may not be sustainable. The market expects earnings may eventually fall.
There are many ways to approach valuing a stock. As complicated or convoluted as a P/E analysis can get, it really only scratches the surface in the comprehensive process the Henssler Research staff undertakes in pinning a price on a stock. Even though the P/E is not a great stand-alone measure of value, the P/E ratio is indeed a useful measure to get a quick idea of a company’s relative valuation. A P/E ratio can also tell you what the market thinks of a stock. For example, if a company has a really high P/E, the market is, typically, telling you it believes the company offers high growth potential compared to peers and market leadership.
The last point to consider is to always double check the data you are using. Many people are taking advantage of the abundance of free stock information available on the Internet. The problem with this is that not all data providers are alike. Some compute the P/E ratio using last year’s earnings, while others use projected earnings or the sum of the most recent four quarters. In addition, projections for growth may be stale or erroneous. Therefore, when you do your research, you can either compute these measures yourself, or be sure to reference several sources and look for consistency in the data to ensure your data provider is accurate. If you find one source to be fairly accurate, be sure to use that source exclusively to avoid using someone else’s potentially bad data. These tips should help make your analysis more useful, and potentially, more rewarding
At Henssler Financial we believe you should Live Ready, which includes understanding which accounts will allow you to save the most for your future. If you have questions regarding your savings strategy, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or email at experts@henssler.com.