Long-term investments in the stock market have tended to outperform most other investments since the mid-1940s. During that time some stocks have performed better than others, and some have not performed well at all. Investment pros have multiple theories about indicators that point to the next winner. One such indicator is the stock's price to earnings ratio, commonly called its P/E ratio, but investment advisers differ on whether a lower or higher ratio is better.
A stock's price-earnings ratio (P/E ratio) is subjectively valued by different investors. A stock with a low P/E ratio typically is less expensive, which indicates that its current price is low relative to its earnings.
Price to Earnings Ratio
A stock's P/E ratio reflects the relationship between the stock's current price and its earnings, typically from the previous 12-month period. For example, a stock with a current price of $10 with earnings of $1 per share would have a P/E ratio of 10 ($10/$1). The stock is said to be trading at 10 times its earnings. The P/E ratio doesn't take into consideration whether those earnings are paid out to shareholders in the form of a dividend or plowed back into the company to fuel future growth.
Low vs. High P/E Ratio
A stock's P/E ratio doesn't indicate whether a stock is good or bad. It only indicates the stock's price in relation to its earnings. A stock with a lower P/E ratio is typically regarded as being cheaper than a stock with a higher P/E ratio. For example, a stock with a P/E ratio of 4 would require four years to earn back your investment, while a stock with a P/E ratio of 12 would require 12 years to do so, assuming everything stays the same.
Stocks with a low P/E ratio may be underpriced in the short term. But if investors spy a bargain and buy these stocks, the purchase activity can drive up the price of the stock. When it does, the investors who bought low make their profit. This is why stocks with a low P/E ratio are often called "value stocks."
Stock Category Comparison
When considering stock P/E ratios, compare apples to apples. Different stock categories have different expectations of price performance. For example, companies in high growth industries are expected to grow faster than companies in mature industries, and they typically have a higher P/E ratio. A high P/E ratio for a stock in a high growth category might be just as cheap for its sector as a low P/E stock in a mature category.
Other Significant Factors
While a low P/E ratio might indicate a cheap stock that has the potential for significant growth, it could also indicate a company that is floundering in the market and is about to go under. P/E ratios are only one indicator of a company's financial well-being. Other significant factors include the company's dividend payout history, its sales trends, new product development, changes in management or business strategy and how well the stock fits in with your overall investment scheme.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.