P/E ratios are a good quick gauge of the value of an investment. It is limited, and there is a ton of additional information to consider when making an investment, but it is a nice quick-view metric.
The P/E ratio of a stock is the stock’s price divided by the earnings per share. So if a stock is priced at $20 per share, and the underlying company most recently earned $1 per share (total earnings divided by the number of shares), then the P/E ratio would be 20 (20/1).
…and so what? Well, a P/E ratio of 20 means that theoretically your investment in a share of that stock is returning 5% of profit. We know this because you can take the same two numbers and reverse the math – $1/$20 = 5%. So for that $20 investment your share of the profits would be 5% (if the profits were returned to the shareholders – which of course they aren’t always).
If the P/E ratio of a stock is lower than 20 it means the stock is returning MORE than a 5% return on investment. A higher than 20 P/E ratio means less than a 5% return.
That’s why when P/E ratios of companies start to get high, then many investors start to question if holding that stock is a good investment or not. It might be still (remember, there are a lot of factors to consider) but certainly this number can give a nice quick and easy view of the stock’s value or theoretical return.
Something else to consider – or at least many people do (I don’t as much myself) is the forward-looking P/E ratio. If the earnings are expected to increase when the next financials are shared, then the P/E ratio at that time (if the stock price remains steady) will drop – meaning a higher ROI.
The reasons I don’t personally care as much about the forward-looking P/E ratio are: 1) the expectations might be wrong and the company might “miss” when they report their next earnings; and 2) I don’t like paying “tomorrow’s prices today”. On that second point, I will take note and then do some additional research. But really the P/E ratio still needs to be reasonable for me to buy in. Many people have bought into companies with super-high P/E ratios (I’m looking at you Amazon, with your current NEGATIVE P/E ratio). The stocks rise (sometimes) so the investors make out okay, but that’s more of an emotional ride-the-momentum type of purchase than one justified by the current financials. (I wish I could run a business that loses money every quarter and has a $141 billion valuation :>).
So, what do you think is a good P/E ratio for you personally? Or do you not even care about P/E ratios (maybe you own AMZN stock)? Is a theoretical 5% return on investment (P/E 20) good for you, or do you strive for better, or maybe even will accept lower?