Everyone knows the investment adage “buy low, sell high”, but that’s easier said than done. Buying an “inexpensive stock” in the hopes that the value will increase is sure to generate more losses than wins over time. But some “cheap” stocks good turn out to be duds.
A low price-to-earnings ratio is one measure of a “cheap” stock but it’s not all it’s cracked up to be as a ratio. Sometimes a better stock over the long run has a high price-to-earnings ratio.
To get to the bottom of this conundrum let’s back up a step in order to answer the question: Is Higher Price To Earnings Ratio Better?
Low Prices Don’t Equal Good Deals
Buying what appears to be a quality stock when the price is lower than usual is generally a good strategy, but it’s not foolproof. That lower price could reflect any number of underlying issues with the company itself or the larger market.
The key is to look at share price in context. How does it compare to the company’s market cap? Its earnings? Its competitors? Is the share price going up because the company is becoming more profitable, or is it simply a result of overall growth in the company’s size?
Experienced investors and market analysts answer these questions by distilling financial data into ratios. That makes it possible to examine potential investments side-by-side and compare performance over time. Ratios remove the extraneous “noise” from business results, allowing investors to compare “apples to apples”.
Speaking of, a company like Apple soared higher to reach market capitalization of $2 trillion because of massive revenue growth, stable margins, great profits, but not necessarily always low price-to-earnings ratios.
The price-to-earnings ratio is an example of breaking financial information down so that it can accurately be compared to the same company’s historical performance or another company’s current state.
Of course, once you have calculated a price-to-earnings ratio, you have to interpret the results. Is a higher price-to-earnings ratio better? If so, why? Would a lower price-to-earnings ratio make the relevant stock a better buy?
What is Price to Earnings Ratio?
Calculating the price-to-earnings ratio requires two pieces of data. The share price and the earnings per share.
Share prices are updated real-time, while earnings per share are updated quarterly. The goal of the price-to-earnings ratio is to measure the value or returns you receive for your investment in a given stock.
The price-to-earnings ratio is calculated by dividing the stock price by the earnings per share for the relevant time period. Keep in mind that companies currently operating with no earnings to speak of – or at a loss – can’t be evaluated through the price-to-earnings ratio.
Two terms you are likely to come across in discussions around price-to-earnings ratios are forward P/E and trailing P/E. The most common is trailing P/E, which is noted as TTM, or trailing twelve months. This term indicates that the ratio is looking back at the year’s actual performance.
Forward P/E is calculated using guidance from business leaders on how they expect the organization to perform over the next twelve months. When relying on this figure to make a trading decision, bear in mind that there is no guarantee that these projections will be accurate.
What Does a Higher Price to Earnings Ratio Mean?
As you compare the price-to-earnings ratios of select companies or the ratios of one company over time, you will notice that some shares trade at a price that is relatively high when earnings are considered.
In other words, purchasing those shares – and related earnings – is more expensive than investments with lower price-to-earnings ratios.
Generally, a higher price-to-earnings ratio means one of two things. First, it could mean that investors expect the company to grow rapidly in the relatively near future. A company like Tesla falls into this category.
Given that expectation, they are willing to pay more, because they believe share prices will continue to rise and/or earnings will increase.
The second possibility is less promising. A higher price-to-earnings ratio can mean shares are overvalued. That means if you choose to buy, you may be paying more than the stock is actually worth.
Overvaluing occurs for a variety of reasons. The most common scenario occurs when there is a sudden rush to buy based on little more than emotion. However, overvaluation can also occur when a company’s financial stability starts to decline.
For example, a company’s stock may be overvalued and have a high price-to-earnings ratio when share prices haven’t yet caught up with poor financial results.
In short, a higher price-to-earnings ratio isn’t always a bad thing, but when considering the purchase of shares in this position, it is critical to uncover the root cause.
What Does Low Price to Earnings Ratio Mean?
A low price-to-earnings ratio can also have multiple underlying causes. There are two possibilities in particular that investors should consider before making a trade.
First, a low price-to-earnings ratio may mean the stock is undervalued. That’s good news for investors, because it offers an opportunity to buy shares “on sale” or at a discount relative to their intrinsic value.
In the vast majority of cases, the market eventually catches up with undervalued shares, bringing them in line with the industry average. That means if successful, you could literally buy low and sell high.
Second, a low price-to-earnings ratio can indicate that the underlying company is doing particularly well as compared to historical results. Google is a good example of such a company.
If earnings increase significantly and share prices haven’t yet caught up, the price-to-earnings ratio will be lower than expected.
Again, this is an excellent scenario for investors, if you are able to identify stocks in this position and buy in. Once you have these shares in your portfolio, you are in the right position to benefit when the market eventually catches up.
Is Higher Price to Earnings Ratio Better? The Bottom Line
The bottom line is that there may be good reasons for some stocks to have higher price-to-earnings ratios, but it is more likely that higher price-to-earnings ratios mean you are paying too much.
Before purchasing shares with higher ratios, research the underlying cause to ensure you have a reasonable shot at seeing an increase in value over time.
Stocks with lower price-to-earnings ratios tend to be a better value dollar-for-dollar, but that doesn’t mean you should blindly purchase any stocks that meet this criteria.
Again, try to determine why the price-to-earnings ratio is particularly low before adding those shares to your portfolio.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.