The price to earnings ratio, or P/E ratio, is a common valuation method for determining whether a stock is overvalued or undervalued.
Price to earnings ratio indicates the amount of money per share an investor is willing to pay today for a dollar of future earnings.
For instance, if Amazon was selling for $18.00 per share today and the company had $1.00 of earnings per share over the prior year, it would be trading at a P/E of 18.
This means an investor would be willing to pay 18 x $1.00 just to own the stock.
The P/E ratio can be an objective method for evaluating stocks…
However, P/E ratios by themselves do not necessarily indicate whether a stock should be bought or sold.
Other factors that affect whether people buy or sell stocks include, but are not limited to:
- Perception and stories
- Dividend yield (if any)
- Price to sales ratio
- Return on equity
- Return on assets
- Market capitalization
- Debt to equity ratio
- Return on invested capital
- Technological and economic industry trends
- Recent market behavior (such as irrational exuberance or pessimism)
People often tell themselves stories (#1) about whether to buy or sell a stock, then use the other factors (#2-10) to rationalize their decision after it is already made.
However, out of all of the above, the price to earnings ratio is perhaps the most well-known.
P/E ratios often vary by company industry, business model and the stage a company is in its lifecycle.
For instance, you should not compare the P/E ratio of a logging company to that of a technology company.
Also, people often mistakenly assume that older, more established companies should have more modest (i.e.
lower) P/E ratios and that younger companies and startups should have higher ones…
But this is only a guideline and may not hold true at all for many companies.
Apple and Microsoft are both about the same age and are both technology companies… However, Microsoft trades at a P/E ratio of 27 while Apple has a P/E of 18.
How Do You Calculate A P/E Ratio?
The P/E ratio can be calculated by dividing the price of a share of stock by the company’s annual earnings per share.
Stock analysts often use “trailing” earnings per share when calculating the current quarterly results of a public company.
What is Apple’s P/E Ratio?
Let’s use Apple stock as an example.
On Thursday August 2nd, 2018 Apple (Nasdaq: AAPL) reached $1 trillion dollars in market capitalization.
This occurrence has caused some people to believe that Apple is extremely overvalued… Maybe it’s to be expected that people would think this, just because $1 trillion is a huge number.
However, look at Apple’s P/E as listed on Google Finance from today.
The stock closed at $209.07 and its P/E ratio is listed at 18.14.
Is this a “good” price to earnings ratio…?
Or is it too high? Too low?
The chart below from Zacks shows the trailing earnings per share for AAPL.
To determine whether Apple’s stock has a high, low or Goldilocks (i.e.
“just right”) P/E we need to look at the price to earnings ratio of Apple and also at the historical trends for the stock market as a whole.
We also need to examine what the stock market “experts” think.
Experts at FactSet believe that the S&P 500 is fairly valued at a forward P/E of slightly over 16.
However, interest rates also play a role in P/E ratios.
In environments like ours where interest rates are between 2-6% research firm FactSet suggests that, at 18.14, Apple’s P/E ratio is exactly where the historical 10 Year trailing P/E ratio should be.
This suggests that even at $1 trillion, Apple is quite reasonable.
Warren Buffett thinks Apple has a very reasonable P/E ratio because he’s backing up the truck on Apple stock, even as AAPL hits new highs…
What do you think about the P/E ratios of tech stocks and the stock market today?