Generally, when we are looking at the price-to-earnings (P/E) ratio, we would prefer to see a lower number for a company that we might invest in. That’s because it’s a basic measure of how much we are paying for $1 worth of earnings. The cheaper the cost the better … with certain caveats.
(Click this link to find out what the P/E/ is and how to calculate it.)
Sometimes a company’s shares are trading at a lower P/E due to macro issues or temporary circumstances. For instance, the price may be depressed because investors have become skittish about the company’s prospects in the face of macro headwinds. The earnings may still be there for the moment, but since the “P” is now smaller, the P/E “number” is smaller (that’s Fractions 101).
Sometimes, the P/E may be low because the “E” is growing by leaps and bounds, but the “P” hasn’t caught up to that fact. Perhaps it’s a sleeper stock that will see the price bounce higher when everyone catches on. That might be a case of the shares being “on sale,” and possibly worth purchasing.
Other times, the P/E may be lower due to problems at the individual company. The price may be depressed because investors see problems with future value. If the price is dropping faster than the earnings, that will create a lower P/E. But just because the P/E has gone down doesn’t necessarily make it a good idea to be a buyer of the company’s shares at that point.
By the same token, certain companies may have high P/E ratios, but that doesn’t necessarily make them a poor investment choice, either. Sometimes the P/E is higher because earnings are anticipated to grow at a fast clip in the near future. Investors may be willing to pay a premium for those “future” earnings before they become a reality. If the stock price “grows into the earnings,” it may turn out to be a good investment.
How to use the P/E
The P/E, all by itself, will not tell you enough to know whether or not you should put your hard-earned dollars into a company’s stock. But it can certainly be one tool among others, to help you make a more thorough analysis of any investment, and on which to base your stock-buying (or -selling) decisions.
Warren Buffett said that he would rather buy a great company at a fair price than a fair company at a great price. The real trick is in assigning numerical values to adjectives such as “fair” and “great.” That is the art of investing. The P/E ratio may be one helpful metric to use in determining those values.
— Answer provided by Motley Fool members Jeb Sturmer and Kathie Ridgeway