A price-to-earnings ratio is a way to value stock that can be useful when making purchase decisions and when conducting ongoing performance monitoring. Its importance, however, lies not in the number itself, but in how an investor uses and interprets P/E ratio calculations. Because long-term goals, risk tolerance thresholds and investing timelines differ between investors, even the seemingly simple, yes-or-no question about whether a low P/E ratio is good can have a variety of answers, each one being correct.
P/E is the ratio of the price and earnings of a share of stock. It can reflect the value of a share of stock for an individual company, an average value for all shares within a specific industry sector or an average value for all shares within an entire industry. The formula for calculating P/E for a single share is market value per share divided by earnings per share, where market value is the current purchase price of the stock and earnings per share are the stock’s current reported earnings. For example, if the market value of a share of stock is $35 and the current earnings per share is $5.25, the price-to-earnings ratio is $6.67. You can look up industry and sector P/E calculations on an Internet site such as TD Waterhouse or Yahoo! Finance (See Resources.)
By itself, P/E is just a statement of fact. It only reveals the value or average value of stock in a single company, sector or industry. This makes getting an idea of where a P/E ratio stands in relation to similar companies or an entire industry the first step in answering the question of whether a low P/E is good. Calculate or look up P/E ratios and then make comparisons. For example, if the industry average shows a P/E of $7.15, then a P/E of $5.25 for a single company is relatively low (Reference 2).
A low P/E, whether based on comparison with another company or the industry average, can mean something or it can mean little to nothing. It can mean something if it signals an overall lack of confidence as to the future of the company or if it signals that the company is at the point in its life cycle where it is no longer growing and an increase in competition is eroding company profits. On the other hand, a low P/E can mean the stock is a “sleeper” -- that is, undervalued. Analyze results by reading -- or re-reading -- a current prospectus and by studying financial records of the company.
Answer the question of whether a low P/E is good by comparing its standings against your risk-tolerance threshold and long-term financial goals. P/E ratios change as often as company earnings do, so a currently low P/E can, for example, not only be good but also be a signal that now is the time to buy. The key is whether research and instinct cause you to believe that a company’s earnings will rebound, stock prices will increase and so will its P/E.
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