Session 08 | What Is a P/E Ratio? | NRICHMINDS Stock Market Investing

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Background

Too Expensive, or a Good Deal?

How do you know when something is too expensive? Or when it's a bargain? A pair of sneakers at a boutique might cost far more than the same style at a department store. Most of the time, when you shop, you weigh the price against what you're actually getting. Investors do the same thing when they look for stocks.

The Price-to-Earnings ratio (P/E ratio) gives investors a way to measure what a publicly traded company is worth, relative to its price. You calculate it by dividing the current price of a share of stock by its annual earnings per share (EPS), the company's profit divided by the number of shares investors have bought.

P/E Ratio = Current Stock Price ÷ Annual Earnings Per Share

Worked example: a company's latest yearly earnings per share is $5, and its most recently reported stock price is $30. $30 ÷ $5 = 6. The P/E ratio is 6.

Some investors would call a P/E ratio like that a "good deal." As a rough rule of thumb:

Below about 15: often considered undervalued, the price is low relative to what similar companies in the industry sell for, and relative to what the company may be worth. Investors buy undervalued stocks hoping the price rises.
Above about 20: often considered overvalued, the price is high relative to industry peers, and may cost more than it's worth. Investors avoid overvalued stocks because they have more room to fall if sentiment turns.
Marked "NA," or not available: the company may have just gone public, or it may have reported a negative EPS (a loss instead of a profit), which makes the ratio impossible to calculate meaningfully.

These 15 and 20 thresholds are rules of thumb, not hard cutoffs, a P/E ratio only really means something when compared against other companies in the same industry, since "normal" P/E varies a lot from sector to sector.

Why isn't $1 of earnings worth the same everywhere? Think of it like shirts. Two shirts can look like they're cut from the same fabric, yet one sells for $20 and the other for $80, because of the brand, the store, and what shoppers expect from each. A dollar of company earnings works the same way: investors will happily pay $30 for a dollar of one company's earnings and only $12 for a dollar of another's, because the two companies aren't seen as equally good bets going forward.

A few of the biggest factors behind that gap:

Growth rate. A company expected to grow earnings quickly usually commands a higher P/E, investors are paying today for profits they expect tomorrow.
Track record and history. A company with a long history of reliably meeting or beating expectations tends to earn more investor trust, and a higher price, than one with a shaky or unproven record.
Competitive pressure. A company facing little competition, or with a strong moat around its business, can often sustain higher, steadier profits than one in a crowded, price-competitive market.
Dividends. A company that pays a steady dividend can appeal to a different kind of investor, and can support a different valuation, than one that pays no dividend and reinvests everything into growth.
Sector or industry. Fast-moving industries like technology have traditionally traded at higher average P/E ratios than slower, more established industries like utilities, simply because expectations for future growth differ by industry.
Supply and demand for the stock. Plain investor enthusiasm, or the lack of it, moves price independently of earnings in the short run, which is exactly what the P/E ratio measures.
Quality and predictability of earnings. Steady, predictable profits are usually valued more highly than earnings that swing wildly year to year, even if the average is the same.
Financial health. A company with a strong balance sheet and low debt is generally seen as a safer bet than one carrying heavy debt, which can support a higher price for the same dollar of earnings.
The broader interest rate environment. When interest rates are low, investors often accept higher P/E ratios across the board, since bonds and savings accounts are paying less, making stocks relatively more attractive.

Key Terms

Vocabulary

Tap a card to flip it and reveal the definition.

Earnings

The money a company has left after subtracting its costs from the money it made selling its products and services. Also called a company's profit.

Earnings Per Share (EPS)

A company's profit divided by the number of shares that have been bought by investors.

Price-to-Earnings Ratio (P/E Ratio)

A company's current price per share divided by its latest annual earnings per share. Describes the relationship between what investors are paying and what the company actually earns.

Risk

The chance of losing all or part of the value of an investment.

Risk Tolerance

An investor's ability to accept loss of some or all of the money they have invested, based on factors like age, financial stability, and how long the money can stay invested before it's needed.

A share refers to a unit of a company's stock.

Shareholders

Also known as stockholders, every investor who owns shares of a company's stock.

Stock

When you buy a company's stock, you become one of its owners. You earn money when the stock's price goes up, and lose money when the price drops.

Value

In investing, "value" refers to how much a company is actually worth, which may or may not match its current stock price.

Goals

Performance Objectives

By the end of this session, you will be able to:

Define and calculate a company's P/E ratio.
Use a company's P/E ratio to make informed investment decisions.

Materials for this session:

Activity Sheet 1 · About P/E Ratios

Springboard Activity

Too Expensive, or a Good Deal?

Ask yourself: how do you know when something you want to buy is too expensive?

Your answer might include not having enough money for it, seeing the same item somewhere else for less, or it just not feeling "worth it."

Now ask yourself: how do you know when something is a "good deal?"

Your answer might include when something is priced well below normal, priced lower than its competitors, or marked "BOGO" or "on sale."

A company's P/E ratio helps investors answer this exact question for stocks. If a stock's P/E ratio is a lot higher than others in its industry group, it may be overvalued, though a high P/E can also reflect high expectations for the company's future performance. A stock with a low P/E may be undervalued, a "good deal," though it could also reflect low expectations for the company's success. The ratio is a starting point for the question, not the final answer.

Activity Sheet 1 · Part 1

About P/E Ratios

Remember, the P/E ratio is the current price of a stock divided by its current yearly earnings per share. A stock that is $20.00 and earns $2.00 per share has a P/E ratio of 10 (20 ÷ 2).

Company*	52-Week High	52-Week Low	EPS	Price per Share	P/E Ratio
Mona Lisa Soup Co.	37.60	28.80	.68	37.41	55.01
Real Grain Foods	50.87	42.41	2.52	49.81	19.77
Jean Pool Enterprises	57.25	47.05	2.31	55.96	24.23
UR Way Foods	36.67	27.44	1.92	34.30	17.86

*The companies used in this chart are fictional. Any resemblance to real companies is coincidental and unintended.

Each company in the chart above is from the food industry. Do any of them appear overvalued? Explain.

MODEL ANSWERUsing the rough rule of thumb that a P/E above about 20 may signal overvaluation, two of these four stocks clear that bar: Mona Lisa Soup Co. at 55.01 and Jean Pool Enterprises at 24.23. Mona Lisa stands out most, its P/E is more than double the next-highest company's, meaning investors are paying far more per dollar of earnings than they are for Real Grain Foods (19.77) or UR Way Foods (17.86), the two companies in this group that look closer to fairly valued.

Which stock is the most expensive, that is, costs the most per share for $1 of earnings? Explain.

MONA LISA SOUP CO.The P/E ratio directly answers this question: it is the price paid per dollar of earnings. At 55.01, Mona Lisa Soup Co. has by far the highest P/E of the four, meaning an investor pays about $55 for every $1 of this company's annual earnings, versus roughly $18 to $24 for the other three.

Which stock seems to be doing well as compared to its 52-week high and low? Explain.

MONA LISA SOUP CO., BY PRICE MOMENTUM

Here is where each stock's current price sits within its own 52-week range, as a percentage from low to high:

Mona Lisa Soup Co.97.8% of range

Real Grain Foods87.5% of range

Jean Pool Enterprises87.4% of range

UR Way Foods74.3% of range

Mona Lisa Soup Co. is trading closest to its 52-week high (97.8% of the way up its range), which on its own could look like the "best performer." But paired with its very high P/E ratio, that same closeness to the high is a caution flag too, the stock has less room left to climb and more room to fall than the others. UR Way Foods sits furthest from its high (74.3% of its range), leaving more room to grow if the company's earnings hold up, worth noting alongside its low, more reasonable P/E ratio of 17.86.

How would you use the P/E ratio to decide which stock to purchase? Explain.

MODEL ANSWERI would use the P/E ratio to compare stocks within the same industry, since a "normal" P/E varies a lot between sectors. A much higher P/E than its peers is a flag to ask why, is the market pricing in real growth, or is the stock simply overpriced? A much lower P/E is worth investigating too, it could be a genuine bargain, or a sign the market expects trouble ahead. I would not use the P/E ratio alone; I would combine it with the 52-week range, the company's growth trends, and news about the business before deciding to buy.

Activity Sheet 1 · Part 2

Research Your Own Comparison

Select three companies to compare from the same industry or sector, ideally from your own portfolio. Using finance.yahoo.com, look up the information needed to complete the chart below.

Company	52-Week High	52-Week Low	Earnings Per Share	Price per Share	P/E Ratio

To be filled in with a live lookup on the day of the activity.

Each company is from the same industry or sector. Do any seem overvalued? Explain.

Which stock is the most expensive, that is, cost the most per share for $1 of earnings? Explain.

Which stock seems to be doing the best as compared to the 52-week high and low? Explain.

Using the information you collected, would you purchase more of these stocks? Explain.

Procedure · Extension

Ranking Riskiest to Most Conservative

Research an industry sector online and look for stocks that appear risky within that group, ones with a higher P/E ratio than their peers. Write down at least three stocks within a single industry, then use the P/E ratio as a predictor to rank the companies from riskiest to most conservative. Be ready to explain your rankings.

Company / Ticker	Industry	P/E Ratio	Risk Rank

General approach: within one industry, the stock with the highest P/E is generally the riskiest by this measure, its price has run furthest ahead of its current earnings, so it has the most to lose if growth disappoints. The stock with the lowest P/E, closest to or below roughly 15, is generally the most conservative by this measure, though a very low P/E paired with weak growth prospects can be its own warning sign rather than a bargain.

Assessment

Building Your Own Comparison Table

Create a table with the following column headings: Company Name, Ticker Symbol, Stock Price, Earnings Per Share (EPS), and P/E Ratio. Complete the first two columns using the names and symbols of five companies currently in your portfolio, or that you would like to include in it.

Company Name	Ticker Symbol	Stock Price	EPS	P/E Ratio

Visit CNBC and use its search function to find the quote information for your selected companies, then complete the rest of the table. As you locate each company's quote, click the Competitors link under Stock Analysis on the left-hand menu to find the same information for its competitors.

What stock looked like it was overvalued? Explain.

Why do you think its P/E ratio was so much higher than the other stocks?

What more do you need to know about this company? Explain.

Application

Buy, Sell, or Hold?

The P/E ratio is the current price of the stock divided by its current yearly earnings per share. A stock that is $20.00 and earns $2.00 per share has a P/E ratio of 10 (20 ÷ 2).

A stock's price per share is currently $30.00 and earnings are $2.00 per share. What is the P/E ratio? If the stock is in the food industry, and the current P/E ratio for a stock in that industry is 17, would you buy, sell, or hold this stock? Explain.

P/E = 15 · BUY OR HOLD$30.00 ÷ $2.00 = 15. That is below the food industry's current P/E of 17, so this stock looks slightly undervalued relative to its peers, a reasonable case to buy or hold rather than sell.

A stock's price per share is currently $60.00 and earnings are $1.00 per share. What is the P/E ratio? If the stock is in the technology industry, and the current P/E ratio for a stock in that industry is 37, would you buy, sell, or hold this stock? Explain.

P/E = 60 · SELL, OR DO NOT BUY$60.00 ÷ $1.00 = 60. That is well above the technology industry's current P/E of 37, so this stock looks meaningfully overvalued relative to its peers, a reasonable case to sell an existing position or avoid buying.

A stock's price per share is currently $70.00 and earnings are $2.50 per share. What is the P/E ratio? If the stock is in the energy industry, and the current P/E ratio for a stock in that industry is 28, would you buy, sell, or hold this stock? Explain.

P/E = 28 · HOLD$70.00 ÷ $2.50 = 28. That matches the energy industry's current P/E of 28 exactly, so this stock appears fairly valued against its peers, a reasonable case to hold rather than urgently buy more or sell.

Grand Master Level

A stock's price per share is currently $96.55 and earnings are $5.00 per share. What is the P/E ratio? If the stock is in the financial industry, and the current P/E ratio for a stock in that industry is 20, would you buy, sell, or hold this stock? Explain.

P/E = 19.31 · BUY OR HOLD$96.55 ÷ $5.00 = 19.31. That is just below the financial industry's current P/E of 20, so this stock looks close to fairly valued, leaning slightly undervalued, a reasonable case to buy or hold.

Enrichment Activities

Companies With No Earnings

Many companies, especially newly public ones, or early-stage companies in biotechnology and technology, report no earnings at all, they are spending more than they bring in while they grow.

Research such a company. Would it have a price-to-earnings ratio? What does this tell you about the company and the risk of owning it? Under what circumstance would you purchase such a company?

DISCUSSION, NOT A FIXED ANSWER A company with no earnings, or negative earnings, generally cannot have a meaningful P/E ratio. Dividing a price by a negative or zero number does not produce a usable comparison, which is why these stocks are often marked "NA." This tells an investor the usual P/E-based valuation tool is unavailable, and that they will need other measures instead, revenue growth rate, cash on hand, how fast the company is spending it (its "burn rate"), and the size of the market it is chasing.

Owning a stock like this is generally higher risk: without current profits, its value rests entirely on investors' belief in its future earnings, which may never materialize. An investor might still purchase such a company if they have a high risk tolerance, a long time horizon, and strong conviction in the company's growth story, essentially betting on the size of future profits rather than measuring today's.