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Ask a Fool: Is the P/E Ratio Useful When Comparing Stocks?

By Matthew Frankel, CFP® – Updated Apr 22, 2019 at 9:32PM

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The most commonly used valuation metric has some key limitations that are important to know.

Q: The most common way I hear analysts value stocks is with the price-to-earnings ratio. How useful is this, and what other metrics are worth considering?

The price-to-earnings (P/E) ratio is certainly a useful tool for investors, but it does have its shortcomings. For one thing, P/E ratios aren't very effective for comparing companies in different industries. Right now, automotive stocks trade for significantly lower P/E ratios, on average, than technology stocks. That doesn't necessarily mean that auto stocks are better long-term investments.

Furthermore, P/E ratios don't take growth into account. Apple (AAPL 1.37%) trades for 12.7 times forward earnings as I write this, while Amazon's (AMZN 3.04%) forward P/E ratio is about 82. However, Amazon's earnings are growing much faster, a fact that isn't reflected in the P/E ratio. Plus, if a company is fast-growing but not yet profitable, the P/E ratio is completely meaningless.

For this reason, I suggest using the P/E ratio in conjunction with a few other metrics. The price-to-book (P/B) and price-to-sales (P/S) ratios are two others that can help you form a better comparison between similar businesses, just to name a couple.

Perhaps my favorite valuation metric is the price-to-earnings-growth (PEG) ratio. This is calculated as the P/E ratio divided by the company's earnings growth rate and helps level the playing field between companies in the same industry that are growing at different rates.

Using my Apple and Amazon example, here's how this works. Apple is expected to grow earnings at a 10% annualized rate over the next three years, giving it a PEG ratio of 1.27. Amazon's earnings are expected to grow at a 45% clip, which makes its PEG ratio 1.82. So Apple is still the cheaper of the two, but they're closer than the P/E ratio makes it appear.

Check out all our earnings call transcripts.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Matthew Frankel, CFP owns shares of Apple. The Motley Fool owns shares of and recommends Amazon and Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

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