The Price-to-Earnings Ratio, also known as P/E, is the most famous financial metric to analyze stocks and the stock market as a whole. We will discuss how the P/E ratio is calculated, how to use, and 11 factors that influence how high or how low it is.
- What is the Price-to-Earnings Ratio
- 11 Important factors to analyze a Price-to-Earnings Ratio
- Other Valuation Metrics
What is the Price-to-Earnings Ratio
The price-to-earnings ratio is the ratio between a company’s market capitalization and its annual earnings or profits. Thus, it can also be calculated as the ratio between the stock price and the earnings per share.
For example, if a stock is trading at $34 and its earnings per share are $2, the price-to-earnings ratio is 17. Such example can be built upon to illustrate various ways to calculate the P/E ratio:
- Total profits: $500 million
- Market capitalization: $8.5 billion
- Number of outstanding shares: 250 million
- Earnings per Share: Total Profits / Number of outstanding Shares = 500,000,000 / 250,000,000 = $2
- Share price: $34
- P/E Ratio: Share Price / Earnings per Share = $34 / $2 = 17
- P/E Ratio: Market capitalization / Total profits = $8,500,000,000 / $500,000,000 = 17
In this way, the P/E ratio tells us how many years of annual profits we are paying to buy that stock. In our previous example, we would be paying the equivalent of 17 times annual earnings to become shareholders of that company.
As a result, the P/E ratio is used as an indicator of how expensive or cheap a stock is. The greater the multiple, the more we are paying for every dollar or euro of profits.
If you are thinking that the secret to investing is to find those stocks with the lowest P/E ratios, let me tell you that it is not that simple.
It may be appealing to buy a stock with a P/E ratio of only 2. This would indicate that the company would generate enough profits in 2 years to fully cover how much we paid for it. But there are many reasons why a P/E ratio might be low. Therefore, it should be used with caution.
If we look at stocks in the S&P 500, we will see some P/E ratios in the hundreds or thousands, some in the low single digits, and some companies without any P/E ratio as it is not calculated if the company is losing money and the E in the equation is negative. The average P/E ratio for the index will hover around 20.
There are many reasons why P/E ratios are so heterogeneous. In the next few sections, we will analyze 11 important factors to consider when analyze the price-to-earnings ratio of a company or a stock market index.
11 Important factors to analyze a Price-to-Earnings Ratio
We will start our discussion by addressing one the myths about stocks with very high P/E ratios.
1) Very high P/E Ratios
First, I would like to clarify why we should not be scared when we see a stock with a very high P/E. Remember than the P/E ratio is not calculated for companies that are experiencing losses. That would not make sense, since the P/E ratio would be negative.
However, if the share price is $34, but the earnings per share is only $0.02, the P/E ratio will be 1700. A P/E ratio this high simply means that the profits are close to 0. If a company has either losses or is breaking even, it does not make much sense to use a metric based on its profits.
The alternative for stocks with very high P/E ratios or no P/E ratio at all, is either to use the forward earnings projected for next year if they are meaningful, or to look at alternative metrics such as the Price-to Sales ratio, the EV/EBITDA, and the revenue growth rate.
2) Growth Opportunities
The potential future growth is probably the main reason that can justify high multiples in a stock. If we thought that the profits of a company would grow at 30% per annum over the next 10 years, we would be willing to pay a very high multiple for it.
The same logic can be used to compare stock market indices. If the P/E ratio of the S&P 500 index is higher than that of the Italian stock market, it is probably because investors believe that growth opportunities for US corporations are much brighter than for Italian companies.
The same logic can be used to compare individual companies, each with its own moats, or sectors. High expected growth rates tend to lead to high valuation multiples.
Related to the previous point, the economic sector of a company is a very important thing to consider. Manufacturing and producing cars, such as Ford, has little to do with developing and selling software licenses, such as Microsoft.
First, and as we have already discussed, the sector has a big influence on the future growth opportunities of a company. The technology and pharmaceutical sectors are likely to grow much more in the next few decades than the energy and financial sectors.
Secondly, we must take into account the most important characteristics of each sector. Sectors with better margins, a less competitive landscape, and less need for large capital investments are awarded higher P/E ratios. One reason why car companies trade at low valuations is because producing cars requires a lot of capital.
Another important aspect is regulations. New laws, regulations and measures to promote certain economic changes, such as the electric vehicle, also influence how companies in a given sector are valued. This can be positive, if governments are expected to throw a lot of money at a certain sector. Or negative, if new regulations will stifle growth and simply increase operating costs.
Any laws, regulations and programs related to climate change and the energy transition are important to consider.
4) Cyclical and Defensive Stocks
Sectors can be divided into two large groups: cyclical and defensive. Although there are people who use a third classification, as we will see later.
Defensive companies can also be called counter-cyclical. Cyclical and defensive stocks react differently to the business cycle. It is one of the factors that most affects the P/E of stocks.
Cyclical companies are those whose profits are highly correlated to the economic and business cycle. Car sales, travel or real estate are perfect examples. When the economy is doing well, more cars are sold, people travel more, both for tourism and business, and there is more activity in the housing market.
The sectors usually considered as cyclical are airlines, automobile manufacturers, banks, hotels, real estate companies and raw materials.
The profits of cyclical companies fluctuate significantly. As a result, their P/E ratio also fluctuates. However, in most circumstances the P/E ratio of cyclical stocks will be lower since those businesses are considered riskier.
On the other hand, defensive or counter-cyclical companies are relatively unaffected by the business cycle. The defensive sectors are utilities, pharma and consumer staples, such as food. Those would be companies such as Nestlé, Iberdrola and Coca-Cola.
Defensive companies have stable profits and therefore act as an insurance when there is a recession. Because of their lower risk, they tend to have higher P/E ratios. In other words: we price of more stable profits is a higher valuation multiple.
Finally, there are sectors that are somewhere between cyclical and defensive. Morningstar classifies these sectors as “sensitive” to the business cycle. These businesses are indeed impacted by the business cycle, but not too much.
Sectors such as technology, energy and industrials are considered sensitive. Thus, companies such as Microsoft, Exxon and Siemens would be in this category. On a relative basis, the P/E ratios of these companies would be higher than that of cyclical companies but lower than defensive companies.
5) Macroeconomic Situation
The state of the economy also influences the valuation of companies. Although not all companies and sectors are affected to the same extent by macroeconomic variables, those have an impact on the entire stock market.
A high P/E ratio for the stock market signals hope among investors that things will get better in the future. The market is paying a high multiple because it believes profits will grow.
For example, we can analyze what happens during a recession. When the economy contracts significantly, corporate profits plummet. Even though stocks may fall, the P/E ratio is likely to expand, because profits fall even more, and investors believe in the recovery of the economy.
Let us assume that a stock is trading at $34 with $2 or earnings per share (EPS) before a recession. When the economy goes south, EPS drops to $1 and the stock price to $20. All of a sudden, the P/E ratio has gone up to 20. This signals that investors believe profits are likely to recover in the future, at least to some extent.
Conversely, a low P/E ratio in the stock market usually predicts some future economic problems. Investors are beginning to think that a recession is possible, or even probable. Since profits are seen as unsustainable, investors are willing to pay a lower multiple.
If we continue with our previous example of a stock trading at $34 with $2 EPS, there might be a temporary boom that pushes EPS up to $3. However, the stock may only go up to $40, pushing the P/E ratio down to 13.3. The lower multiple indicates investors believe profits will go down to some degree.
6) Interest Rates
Interest rates in the economy heavily influence stock valuations. The fixed income market is the largest in the world, bigger in size than the stock market. Between the two, there is a constant flow of capital from one to the other, depending on which one looks more attractive in the short and long term, given the state of the economy.
Consequently, we can say that there is a competition between bonds and stocks to attract inflows of capital. The higher interest rates are, the more attractive it becomes to invest in bonds, and the less money flows into the stock market. On the other hand, lower interest rates tend to lead to more money flowing into stocks.
The main reason why the US stock market was so cheap in the early 1980s is because interest rates had been raised to about 20% to combat inflation. Subsequently, as both inflation and interest rates fell, valuation multiples expanded, and the market experience a massive rally.
Additionally, low interest rates also allow companies to borrow heavily. This leverage can be used to finance stock buybacks, reducing the number of outstanding shares, making EPS higher and pushing up stock valuations.
7) Geopolitical Factors
Geopolitical considerations are something investors pay attention to. For example, the country where a company is domiciled or the markets in which it carries out its business activities.
Where the company’s headquarters are located determines how much taxes are paid, applicable regulations and laws, and the level of technological innovation. Where a stock is listed determines investors’ appetite to invest.
Stocks from developed countries with strong rule of law tend to carry higher multiples. This is one of the reasons why most emerging markets tend to look cheap relative to developed markets.
Where business activities are carried out is also important. For a mining company, investors pay attention to the jurisdictions in which its mines are located. For an industrial company, it is about where factories and supply chains are located. And for most companies where products and services are sold.
8) Level of Debt
Debt is one of the most dangerous things for a corporation. It is key to understand the financial situation of a company. The higher the leverage, the greater the potential for profits, but also the greater the risks.
Companies with very high levels of debt are riskier and will trade at lower P/E ratios. Remember that debt is not considered when calculating the P/E. But debt has to be serviced before there is any money left for profits and dividends.
As a result of that, the profits of highly indebted companies are very unreliable. If revenue goes down, profits are likely to evaporate all together as the interest costs will either remain unchanged or increase.
An additional risk for highly indebted companies comes in the form of higher interest rates. If rates go up significantly, these companies will have more difficulty refinancing their debt. Consequently, they will end up paying much higher interest rates and profits will get affected.
9) Idiosyncratic characteristics of a company
Intangible and idiosyncratic characteristics of a company are also important in determining the price-to-earnings ratio. Things such as the value of the brand or having a genius CEO are taken seriously by investors.
Thus, a company whose brand has a very good reputation may have a higher P/E ratio than a similar company that is not well known. Coca-Cola or Nestlé would be good examples. The intangible value of that brand is reflected in the company’s stock price and valuation metrics.
A genius CEO, such as Elon Musk, can also impact the valuation of a company. If Elon Musk were to step aside, the stock price of Tesla would likely be hit hard.
10) Social and Environmental Factors
A company’s social and environmental factors can influence its P/E ratio. For example, having good and effective governance, treating employees well or not polluting the environment are positively regarded by investors. The importance of these factors comes down to the following two reasons.
First, a company that has satisfied workers and complies with environmental legislation faces fewer risks of either strikes or environmental lawsuits. This translates into healthier and more stable profits and, therefore, a higher valuation multiple.
Second, investment funds with a focus on social and environmental criteria are growing strongly. Such trend is known as ESG (Environmental, Social, Governance). These investment funds exclude certain sectors or companies. They also overweight stocks that rank higher in terms of social and environmental metrics.
11) Overvaluation and Undervaluation
The final point is something that many readers were anticipating. How can we identify which companies are expensive and which ones are cheap? Unfortunately, it is not as easy as simply looking up the price-to-earnings ratio of a company, sector or market to decide if we should buy or sell.
However, we can certainly analyze the markets. There are two main types of analysis that we can carry out:
On the one hand, we can analyze individual stocks to find out if they are expensive or cheap. This type of micro analysis at the company level will require, among other things, that we compare a stock with its peers.
For example, to find out whether Daimler is expensive or cheap, we will look at how other vehicle manufacturers are trading and analyze the entire sector. Hopefully, we will identify which companies are cheap and should be bough, and which ones are expensive and should be sold.
On the other hand, we can use the price-to-earnings ratio for macro analyses. This will allow us to assess if the stock market of a country, or even the global stock market, is cheap or expensive. Of course, such conclusions are relative to other historical periods and the state of the economy and the world.
From those conclusions we will be able to determine if we want to invest more or less heavily in specific markets, or even in different asset classes. Based on our assessment of the stock market, we may decide to invest more heavily in bonds.
Other Valuation Metrics
The P/E ratio should never be used on its own. While it is a very powerful metric to analyze both individual companies and large groups of stocks, more information is required to form an opinion that will be useful to take investment decisions.
Additional information can be numeric, such as when we look at price-to-sales ratios, growth rates, inflation numbers or interest rates, or qualitative, such as customer loyalty, brand reputation, investor sentiment or the geopolitical situation.
If you want to learn more about analyzing stocks and the stock market, check out the following section:
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