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An Investor's Guide to the P/E Ratio

By Motley Fool Staff - Jun 17, 2016 at 8:04AM

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Everyone considering a stock investment needs to understand this famous yardstick.

The price-to-earnings ratio is one of the most examined, cited, and important pieces of company information available to investors. At its heart, it's a very simple measure of two key items that can tell us a great deal about how the market is valuing a particular stock.

In this clip from the Industry Focus: Tech podcast, analysts Dylan Lewis and Simon Erickson explain what the P/E ratio measures, what it signals about a company, the two ways it's broken down (and what each indicates), and how to look at the number in context to get more benefit from it.

A transcript follows the video.

This podcast was recorded on June 3, 2016. 

Dylan Lewis: Just as a reminder, the P/E ratio is the price-to-earnings ratio. This measures a company's current share price against how much it actually earns in per-share income.

There's typically two different ways you're going to see this broken down. Either TTM, which is trailing 12 months, and so that's looking back at what the company has actually posted in earnings; and then a forward basis. That's taking analysts' estimates of earnings expectations and then applying it to the current share price. Do you put more merit in one or the other, Simon?

Simon Erickson: I mean, the estimates are just estimates, right?

Lewis: Yeah.

Erickson: This is typically a consensus estimate of what a lot of analysts think the company is going to do in the future. It may or may not look like that, but the trailing 12 months is what they actually did do, so I guess that's the biggest differentiator between past and forward.

Lewis: If you see a company with a lower forward P/E, it should be because the company should be growing?

Erickson: Hopefully, yes.

Lewis: That's what you want to be seeing. If it's higher, then the company is probably not doing so great.

Erickson: Yeah, exactly.

Lewis: Just an example of how this works. Apple ( AAPL -1.17% ) currently trades for just under $100. It has trailing-12-month earnings of just, like, $9 per share, roughly. That gets you a P/E, a trailing P/E, of almost 11. Forward P/E, it depends on the estimates you use. You'll see that number fluctuate quite a bit. For Apple, most forward P/E estimates fall in the 10 to 12 range. P/E is often cited as this very quick at-a-glance for a company's valuation. It's a number you can kind of wrap your head around very easily, but on its own, at least in my opinion, it's kind of meaningless. I don't know what your thoughts are there, but to me it's all about putting it up against peers or against the broader market itself.

Erickson: Yeah, that's right. It's probably the most common traditional metric for valuation of looking at stocks. Just, OK, "What's the P/E ratio?" to kind of give you a general feel for how expensive a stock is or how inexpensive. The reason we say that is because basically the price, the numerator, is the market cap divided by the trailing or the forward earning, and you've got to think of that top one as the market cap is just a function of what the market is willing to pay in relation to $1 of forward or of trailing earnings. That's why we say "expensive" or "inexpensive." It's basically, a higher P/E is a company is being rewarded with a higher market cap per dollar of earnings, which is kind of representative of what the market thinks of them.

Lewis: I largely think of P/E as a signal of growth expectations, and that kind of plays into what investors are willing to pay now. It's really, "What does the market expect from this company?" You look at your high-P/E companies; market's basically saying, "We expect this company to be making a lot more [money] in the future, and we're willing to pay up for it now to enjoy that ride, that share-price appreciation that comes along with it." Low-P/E companies, the market is saying: "We don't really expect a ton of growth from your business. We don't expect it to outpace your competitors or the broader market." I think actually, right now, Apple is kind of a good example of that. You look at them, their trailing basis, like I said, around 10 or 11. The broader market is in the low 20s. You look at some of their competitors, like Microsoft, they're actually up in the low 40s right now. That disconnect in valuation is the market signaling we don't expect Apple's growth to outpace the broader market's growth rate.

Erickson: Yeah, a great point you pointed out. What point of the life cycle of this company are we in right now? Are we a super-fast-growing, early stage company that should be plowing most of its money into the company itself to grow faster, or we are an established company that's been around for decades and everybody is using its products and it's pretty stable growth? Not remarkable growth, but you want to be paying out more of those earnings in forms of dividends or stock buybacks, rather than plowing them right back into the business to go after more growth.

Lewis: Yeah, and the idea there is if you're reinvesting it in yourself, the ability to grow the business and the growth rates you'll achieve by investing that money in is better than what you'd be giving shareholders via a dividend.

Erickson: Exactly.

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