Understanding Price To Earnings Ratio

If you have been dabbling in the stock market and actively analyzing quarterly reports, you will be familiar with this term, Price to Earnings. For better or worse, Price to Earnings(PE) is one of most popular valuation ratio.

What I like about the PE ratio is that earnings reflect better on cash flow than sales and they are more current than book value. Earnings per share are also easily available and computable.

However, what determines an attractive PE ratio? A PE ratio of say, 10-12, is meaningless as a standalone figure. It must be relative to other benchmarks, such as another company, entire industry, general stock market. Or it can be used for same company at different point of time.

Each of these approaches give you an insight into the company but there are limitations. A company that is trading at a lower PE ratio is a value buy provided capital structures, risk management and growth rates of companies in the same industry are taken into consideration.

To put it in simpler terms, I prefer to invest in a firm with a higher PE ratio that is growing faster, has less debts and lesser need of recapitalization.

If you are comparing a company's current PE ratio with its historical P/E, then it is pretty straightforward, especially for stable firms. A blue-chip company that is growing at the same rate as its competitors but trading at a lower P/E is obviously a good catch.

To go a step further, let's consider what affects the PE ratio so much that the market prices one higher than the other?

As a rule of thumb,

Higher growth = higher PE ratio
Higher risk = Lower PE ratio
Higher capital needs - Lower PE ratio



A company which exhausts capital fast requires additional funding in the form of debts (more risks) or issuing new shares (dilution of existing stockholders' stake). In either case, every dollar of earnings require more capital, so why pay a high price for these companies?

When using the PE ratio, it is important to look at the free cash flow. If it is strong, then the company needs very little recapitalization, some other things which may distort a P/E ratio include:

1. Is there a one-time gain from sales of a subsidiary or asset?

Watch out for the E in the PE ratio because if it doesn't make sense, there is definitely something fishy going on.

You cannot get excited or value a firm based on such one time gains. A conservative evaluation requires you to subtract the proceeds before tabulating the P/E ratio. The company may turn out to be not that cheap after all.

2. Is there a big charge recently?

This usually happens when a company is in the midst of restructuring or closing down plants. For valuation, add back the charge to get a sense of a PE ratio when the company is operating normally.

3. Beware of business cycles

Every company goes through bust or boom business cycles. Some fare better than others. For electronics and automotive industries, they symbolize the harsh realities of cyclical earnings.

If a firm exhibits low PE ratio, do not jump right in. Check if the firm is cyclical as this could be the wrong time to pick them up. Previously, they may have high earnings but have now fallen off, so if you invest, it could be a long wait before the industry enjoys a new lease of life.

The best approach is to look at the most recent cyclical peak and assess if the next peak is likely to be lower or higher than the last one and work the PE ratio backwards from there.

4. Does the firm inflate earnings by capitalizing expenses?

A company that makes money by manufacturing or building usually capitalize the huge expenses as an asset and then reduce this asset(expense) through yearly depreciation.

On the other hand, inventing products are the source of revenue for some companies, like like drug firms which have to expense ALL its spending on research and development every year.

Such spending on R&D are good for investors as it creates value. Thus, the firm that expenses assets will have lower earnings and thus higher PE ratio than those that capitalizes assets.