P/E ratios?

Question

Generally, the higher the P/E ratio the better because that means the company is growing faster, but then again it could be over valued.

The lower P/E ratio is not good obviously because the company's growth is at a stand still, but once again, it might be undervalued.

So, how do you determine if a stock is undervalued or overvalued and what role does the P/E ratio play in it?

Answer 1

P/Es are very much dependent on industry.

Historically, I think the S&P 500 companies sit between 15x and 20x.  

P/E is an indicator of future earnings - the higher they are now, the higher you expect growth in earnings to be.  So the more mature the company, the lower the P/E should be because of fewer growth prospects (the larger you are, the harder it is to grow since projects will consist of an ever-lower proportion of your total equity value).

Roughly speaking,

For banks, they generally sit between 8-11.

Non-tech blue chips sit on the lower end of the teens.

Blue chip tech stocks like Cisco and Msft sit between 20-30, and newer tech stocks like Google and Amazon can sit anywhere between 40 and 60, though 60-65 is pushing it.

These are very rough indicators, but are generally OK to go by.  

So how to use these guidelines?  

Never buy a stock purely based on P/E, but stocks that sit outside these ranges can be an indicator for further research needing to be done e.g. if a bank sits at 5x, it could be undervalued, or if a growth stock sits at above 100 (las vegas sands, research in motion), might be an indicator to get out.

Forward P/E, which uses EPS estimates as the denominator, are also a good indicator to look at along with traditional P/E.

Answer 2

The P/E ratio is simply the ratio of the price per share of the stock divided by earnings per share.  It does not measure growth in any way.  The P/E ratio can jump around a bit when you have unpredictable earnings (good years followed by bad years).  The P/E ratio is also sometimes referred to as a multiple.  Investors are usually willing to pay a higher multiple of earnings if a company has an above average growth rate.

Just remember that no company can grow at an above average growth rate forever.  As soon as a company's growth starts to slow down, the stock will get hammered because it no longer justifies a high P/E ratio.

A good way to tell if a stock is undervalued or overvalued is to compare the P/E ratio to the company's growth rate.  This ratio is called the PEG ratio and is just the P/E figure divided by the growth rate.  If this number is less than 1, it tells you that the company is growing at a faster rate than the P/E multiple that investors have come to agreement on the value of the stock.  This means you might have just found an undervalued stock.

Answer 3

The P/E ratio looks at a companies future relative to its past. The price is the present value of all FUTURE cashflows. The earnings come from the financial statements and represent past earnings (generally from the last quarter).

So, the P/E ratio tells us how much investors are willing to pay for each dollar of past earnings. For instance if a stock has a P/E ratio of 1, then investors are willing to pay $1 for each $1 of earnings. If the P/E ratio is 20, then investors are willing to pay $20 for each $1 of earnings. This tells us how much of a premium investors are willing to pay for a particular companies earnings  - the higher the P/E , the more they value the stock...Hope this helps

Answer 4

I like to use the earnings yield, which is the opposite of the P/E ratio.  Next year's earnings/current price.  Subtract the current yield on the ten year note from that amount.  Thats the risk premium.  The higher it is the better the expected return.