Are stocks with low P/E ratios always better?

Stocks with high price-to-earning ratios can be overpriced. So is a stock with a lower P/E ratio always a better investment than a stock with a higher one? The short answer? No. The long answer? It depends.

The P/E ratio is calculated as a stock’s current share price divided by its earnings per share (EPS) for a twelve-month period, usually the last 12 months, also called the trailing 12 months. Most of the P/E ratios you see for publicly traded stocks are an expression of the stock’s current price compared with its previous 12 months’ earnings.

A stock trading at $40 per share with an EPS of $2 would have a P/E ratio of 20 ($40 divided by $2), as would a stock priced at $20 per share with an EPS of $1 ($20 divided by $1). These two stocks have the same price-to-earnings valuation; in both cases investors pay $20 for each $1 of earnings.

However, what if a stock earning $1 per share was trading at $40 per share? Then we’d have a P/E ratio of 40 instead of 20, which means the investor would be paying $40 to claim a mere $1 of earnings. This seems like a bad deal, but there are several factors that could mitigate this apparent overpricing problem.

First, the company could be expected to grow revenues and earnings much more quickly in the future than companies with a P/E of 20, thus commanding a higher price today for the higher future earnings. Second, suppose the estimated (trailing) earnings of the 40-P/E company are very certain to materialize, whereas the 20-P/E company’s future earnings are somewhat uncertain, indicating a higher investment risk.

Investors would incur less risk by investing in more-certain earnings instead of less-certain ones, so the company producing those sure earnings again commands a higher price today.

It must also be noted that average P/E ratios tend to vary from industry to industry. Typically, companies in very stable, mature industries that have more moderate growth potential have lower P/E ratios than companies in relatively young, quick-growing industries with robust future possibilities. Thus, when an investor is comparing P/E ratios from two companies as potential investments, it is important to compare companies from the same industry and with similar characteristics. Otherwise, if an investor simply purchased stocks with the lowest P/E ratios, he or she would likely end up with a portfolio full of utilities stocks and similar companies, which would leave the portfolio poorly diversified and exposed to more risk than if it had been diversified into other industries with higher-than-average P/E ratios.

However, this doesn’t mean that stocks with high P/E ratios cannot turn out to be good investments. Suppose the same company mentioned earlier with a 40-P/E ratio (stock at $40, earned $1 per share last year) was widely expected to earn $4 per share in the coming year. This would mean (if the stock price didn’t change) that the company would have a P/E ratio of only 10 in one year’s time ($40 divided by $4), making it appear very inexpensive.

The important thing to remember when looking at P/E ratios as part of your stock analysis is to consider what premium you are paying for a company’s earnings today and determine if the expected growth warrants the premium. Also, compare the company to its industry peers to see its relative valuation to determine whether the premium is worth the cost of the investment.