Many stocks were pummeled by the long and severe market downturn. As a result, you can now find plenty of good, quality stocks selling at low prices. On the other hand, some companies belong to industries whose near-term future looks uncertain — and even though these stocks, too, may be inexpensive, they aren’t necessarily good deals. So, how can you tell the difference between good stocks selling at temporarily low prices and not-so-good stocks selling at deservedly low prices? One tool that may help you is the price/earnings ratio, or P/E.
When looked at mathematically, P/E is a simple concept — it’s calculated by dividing the current stock price of a company by its earnings per share. So, for example, a stock that is now priced at $40 and has $2 of earnings per share will have a P/E of 20. Generally speaking, a stock’s P/E reveals how much investors are willing to pay per dollar of earnings. So, for the stock mentioned above, its P/E of 20 implies that investors are willing to pay $20 for every $1 of earnings that the company generates. It follows, therefore, that the higher the P/E, the more “expensive” a stock is perceived as being.
Because the average P/E in the stock market has been around 15 over the past 50 years, one might say, in a broad sense, that a stock with a P/E of 20 is neither terribly expensive nor particularly cheap.
Overall, the P/E ratio is typically a good indicator of a stock’s value — and a much better indicator than the price alone. To illustrate: A $20 stock with a P/E of 70 may actually be much more “expensive” than a $100 stock with a P/E of 20. As an investor, you’re paying much more for the future earnings of the $20 stock than you are for the earnings of the $100 stock. So, in the present-day situation, with the market still down so much, you might be able to use P/E to get a clearer sense of which stocks are really priced attractively and which ones are expensive, despite their low market price.
Keep in mind, however, that a low P/E doesn’t automatically mean that a company is undervalued. One way of interpreting P/E is as a measure of the market’s optimism about a company’s growth prospects. So, if a company has a P/E that is lower than average, it could mean that the market has low expectations for this company.
Furthermore, just looking at a stock’s P/E in isolation can’t always tell you if it’s a good deal. For that, you also need to compare its P/E with other stocks in the same industry. That’s because some industries, such as utilities, typically have low P/Es, while others, such as technology, generally have higher ones.
As you can see, you’ll need to consider a few “wrinkles” in P/E before using it to evaluate whether a stock is priced attractively. Consequently, you may want to get some help from a financial advisor. But one thing to keep in mind: Right now, you can find attractive prices on quality stocks — and the correct use of P/E may well help you find the best ones.
• This article was written by Edward Jones for Cyndi Newburn, an Edward Jones financial advisor in Ahwatukee Foothills. Reach her at (480) 460-1149.