When you're investing, the last thing you want to do is pay too much for a stock or miss an opportunity to get a bargain price. This is where a company's price-to-earnings ratio comes into play, and not all P/E ratios are the same. What makes a P/E ratio good or bad depends in part on your style of investing, which is generally based on your goals and risk tolerance. Also, a company's valuation, which is another way to characterize its P/E ratio, is relative based on the industry in which the business operates.
A P/E ratio illustrates where a stock is currently trading based on its past or future earnings performance. A trailing 12-month P/E ratio reflects the stock price based on earnings over the past four quarters, while a future P/E ratio illustrates where a stock is trading based on profit projections. While a P/E ratio alone doesn't tell you whether a stock is a good investment, it does indicate whether or not investors are demonstrating confidence about future returns.
One way to gauge whether a P/E ratio is good is to compare it to the market average. The average P/E ratio for the S&P 500, which is a market index that represents trading in the broader stock market, was 15.3 in January 2013, which fell below the long-term average of nearly 19.0. This suggests that stocks were trading inexpensively during the month, according to a 2013 "USA Today" article. As a result, some of the stocks trading at a lower-than-average P/E could represent a buying opportunity that might lead to future profits.
Another way to judge a company's P/E ratio is to compare it with the industry. When discount-airline Pegasus began trading on Turkey's stock market with a P/E ratio of more than 14.0, the valuation was about twice the size of industry rival Turkish Airlines. Pegasus was trading more expensively and investors appeared to get a bargain by investing in Turkish Airlines. Nonetheless, analysts expected that Pegasus' earnings were rising, which would lead to a higher P/E ratio, according to a 2013 article on "The Wall Street Journal" website. In this case, Pegasus was the one trading at a good price.
Growth and Value
Value stocks are companies that are trading at beaten-up, or low, P/E ratios, but nonetheless may have some catalyst for future earnings growth. Growth stocks, on the other hand, are expensive. They trade at higher P/Es based on recent earnings growth and investor expectations for similar performance in the future. According to a 2012 article on the "Forbes" website, a good P/E for value investors is one that doesn't surpass a company's growth rate, while growth investors aren't deterred by a high ratio as long as a company is increasing its profits, sales and margins.
Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.