Why is there so much variation in P/E ratios of different companies?

The price to earnings ratio (affectionately known as the P/E) can be a valuable metric for judging the relative worth of a company as an investment.

However, it can’t really provide a relevant comparison for companies in fields as different as software (apples) and restaurants (oranges). Think about real estate — you wouldn’t compare the cost per square foot in a swanky beachfront condo to a warehouse in an industrial district in the middle of the country.

 

Likewise, for the best use of P/E, it should be compared within industry categories … apples to apples.

So the P/E of software companies is compared to that of other software companies. Restaurants are compared to other restaurants, and so on.

One reason is that different industries/sectors typically sport different relative levels of P/E.

What kinds of companies might have a low P/E?

Huge, staid, well-developed corporations that are no longer considered high-flying, high-growth candidates are one example of low-P/E companies. For instance, Exxon Mobil‘s P/E tends to hover near low double digits, as does Chevron‘s.

What kinds of companies might have a high P/E?

One example would be promising upstart companies with barely discernible earnings, which will generally show a higher P/E ratio. That might be because investors are willing to pay a premium for the anticipated earnings to come, believing that the company will successfully surmount hurdles and become profitable enough to justify the premium paid (they’ll “grow into” their P/E).

Comparing the P/E of different companies

The P/E, in and of itself, will not tell you nearly as much as comparing the P/E to different companies within their respective sectors. So just knowing that Exxon’s P/E is near 10 tells you one thing, but knowing it is in line with similar companies tells you more. If Exxon had a P/E of 62, that would tell you that you should delve further into the reasons it is not in line with its industry average.

Nevertheless, merely knowing the P/E of a company, or how it relates to other businesses within a sector, will not give you a definitive piece of information as to whether you should invest in a company’s shares. It is but one of several informational metrics to utilize in giving you a more complete picture of the viability of investing in a company.

There are lots of other factors that go into a measured decision to invest in one company over another. Even given the same data, the answer for different people will vary, depending on their respective time horizons, financial situations, and risk tolerance, etc.

Click the links for more information about what the P/E ratio is and how to use it, and whether you want a high or low P/E when looking for stocks.

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