In my last article, I reviewed the method I use to pick stocks for the Cookie Jar portfolio. One of these items was using the P/E ratio as a factor to determine whether a stock is worthy. Today I want to dive in deeper into P/E ratios: what they are, how to use them, and all in all breaking them down.
Price to Earnings Ratio
What is a P/E ratio? A P/E ratio is the price to earnings ratio of a stock. This is calculated by dividing market value per share by the earnings per share of a company. If that doesn't make sense to you, I'll give you a quick example:
Sample Company B
Current trading price: $50/share
Earnings over the last 12 months: $3
In order to calculate Company B's P/E ratio, we simply plug in the above numbers like so:
50 divided by 3 which would equal 16.6*repeating.
Typically you want to make sure to use the last year of the stock's earnings to gain an accurate representation of the true P/E but sometimes if you pay attention to analyst reports (I don't, they're mostly garbage), they will use what they feel are estimated future returns which throw the whole value off in either direction.
Simply put, in the above example, investors all over the world would be saying that they believe that the company is worth $16.6 for every one dollar of the company's earnings. This can tell you a lot about what the market feels the company is worth but it can also be a pitfall if you rely too much on it. That was simple, right? Calculating the P/E of a stock is very easy and is one of the greatest ways to quickly evaluate a stock to make sure that you're not throwing money at a losing bid.
Pitfalls to using P/E
The first thing that comes to mind when thinking of potential setbacks of primarily using the P/E ratio is that like old cars, they're seen very different by car enthusiasts and the rest of the population. Let's use that as an example. If you had a 67' Mustang and you restored it to the former glory that it once had, car enthusiasts all over would be willing to pay good money for your restored beauty. Unfortunately, the car is actually still just a 67' Mustang and only worth a few thousand at best to the general population that is simply looking for a pair of wheels to get around in. Now imagine that your car loving crowd suddenly starts hating the 67' Mustang and moves on to another love. Your Mustang that was once worth twenty times its real value to this select crowd is now only worth what the rest of the world thinks of it and you've effectively drained tons of money restoring it to make a capital loss if you have to sell it. P/E ratios are very much the same. There may be a company that is loved by many that is valued far beyond the normal P/E ratio because of a crowd of people that believe it's somehow worth that much more even though its earnings can't keep up with the love that people give it. If that crowd suddenly turns on it, you've suddenly got a company that you paid lots for that really only makes a fraction of what you invested into it in earnings. Your share price falls and you lose tons of money. This is a key reason to not solely base your opinion of a stock on its P/E ratio.
Another pitfall that goes hand in hand with the above is that different sectors play differently with their P/E ratios. Some sectors may see a norm of up to 30 P/E ratios. This is a little too inflated for the normal dividend growth investor when peered at from the outside but if one simply looks at the rest of the sector and realizes that the sector itself shows this as the norm, it's not so bad. Be careful however as the whole sector may be like the first pitfall example; they may be one big 67' Mustang group just waiting to move on to something else.
**Note: I don't hate the 67' Mustang like this article may seem to imply... sorry!
Lastly, I want to remind everyone that the entire formula for P/E ratios is in itself slightly flawed. Because the ratio focuses on using the earnings reported by a company themselves, you could just as easy be trusting information that is not correct. It wouldn't be the first time that a company lied about their earnings. Keep this in the back of your head if you ever run into the whole "too good to be true" company that you're looking to get a piece of action out of.
Now it's your turn
What other pitfalls have you run into with P/E ratios? Do you use the P/E ratio or do you avoid it like the black death?