Today we’re breaking down Price to Earnings (PE) Ratios and answering the question: What is a good PE value? My guidelines are generally as follows:
For a large, growth oriented, a good PE ratio is below 30.
For a large, value oriented company, a good PE ratio is below 15.
This is a highly nuanced subject and needs a deep dive and the above statements do not work in every case. So let’s break this down!
What is a PE Ratio?
The Formula
A PE ratio is simply:
Price / Earnings Ratio = Share Price of Company / Trailing Twelve Months (TTM) Earnings Per Share (EPS); or
Price / Earnings Ratio = Market Capitalization of Company / TTM Net Income
Example Calculation
When evaluating on a single company basis, the calculation is quite simple. First, simply identify the current share price or market capitalization of a company. This can be done with a simple Google search or via your brokerage account provider.
Once you have that, you can open up a tool like Seeking Alpha to identify TTM net income or earnings per share. Conversely, you can go straight to the source and pull a SEC filings. You’ll want the last twelve months of earnings, so you’ll need a 10k and/or a series of quarterly 10Q’s. Whatever is most recent.
I recommend an aggregator like Seeking Alpha for beginners in order to gather this data.
As a base example, let’s say a company has a share price of $100 and a TTM EPS of $5. Applying my formula above, you would get:
100 / 5 = PE of 20
Interpreting a PE Ratio
Basic Concept
Now that you have your PE ratio, what exactly does it mean? What it is saying is that, based on TTM earnings, if you make a $100 investment, you’re earnings yield is $5, or 5%.
Put another way, say you open a business with a friend. You both own 50% each and we use the same example as above. Your $100 investment is 50% of the business and the business earned $10 last year. That means your EPS is $5.
If you pulled out 100% of the earnings of the business, you’d have $5. Divide the $5 earnings by your $100 investment and you get a 5% yield. Assuming the businesses never grows or contracts, it would take you 20 years to recoup your investment.
This needs some context though, right? What if your business is growing by 200% each year? What if it has one foot in the grave? Let’s discuss.
Impact of Future Expected Performance on PE Ratios
Like mentioned above, the future prospects of a company have an extreme impact on the PE ratio of a company at a given time. Let’s expand on the two examples above of a high growth and a failing company.
For a high growth company, the TTM earnings are vastly understating your future earning potential. So you would be willing to purchase shares at a premium to current earnings. This will allow you to reap future rewards. This tends to inflate PE ratios. But this also brings added risk, as you’re relying heavily on future returns to derive a benefit from the investment.
For a low growth company you expect that future returns will not grow as much, or maybe not at all. Therefore, you are less willing to pay a premium for the stock. This tends to depress PE ratios as you are more reliant on current earning levels to recoup your investment.
As a quick cheat sheet, the general trend is as follows:
- Growth Stocks Trade At Higher PE Ratios
- Low-Growth / Value Stock Trade At Lower PE Ratios
Industry and Peer Comparisons
A PE Ratio is typically not very helpful when evaluated in isolation. They are much more effective when comparing to their competitors or other industry participants.
- If a company is trading at a lower PE versus its peers, it may be undervalued. However, it may have lower future growth prospects.
- If a company is trading at a higher PE versus its peers, it may be overvalued. However, it may have greater future growth prospects.
I therefore have to stress: An investor should always use a PE ratio as a comparison to its peer values.
Additional Shortfalls of the PE Ratio
There are a couple of major shortfalls of a PE ratio that should be taken into consideration. A few are:
- Companies that do not have positive TTM earnings could be unnecessarily ignored.
- One-time items such as goodwill impairments, settlements, etc. can distort TTM earnings and therefore PE ratios.
Investors should always understand a company’s net income and if adjustments are needed.
What Is A Good PE Value?
Methodology
If you couldn’t tell yet, a good PE value is extremely difficult to have a “one-size-fits-all” approach with. However, we can put some guard rails around the PE values we see and want to omit/scrutinize heavily.
If we look at the S&P 500 historically, over the last 40 years it has returned a PE ratio of 22.64. This can be a good baseline to determine if a company is trading at a premium or discount to the broader market. This is generally what I do.
What Is A Good PE Value?
To bring us back to the original question, here’s what I personally do:
For a large, growth oriented, company I will generally target a PE ratio below 30. This allows a level of buffer above the S&P 500 historic PE and takes into account that the company is growth oriented. Anything above 30 I either ignore, or a spend extra time digging into why it is above 30.
For a large, value oriented company, I will generally target a PE ratio below 15. This provides a similar buffer on the downside of the historic S&P 500 PE. Remember, a value oriented, lower growth company, we tend to see lower PE ratios. So if I find a value stock trading above 15, I generally ignore it or re-confirm my hypothesis that it is actually a value stock.
DISCLAIMER – THIS ARTICLE IS NOT FINANCIAL ADVICE. THIS ARTICLE DOES NOT CONSTITUTE A BUY, SELL, OR HOLD RECOMMENDATION ON ANY SECURITY MENTIONED HERE. THIS ARTICLE CONSTITUTES MY OPINION AND NOT A STATEMENT OF FACT. ALL INFORMATION REGARDING THE FINANCIAL SECURITIES MENTIONED IS ACCURATE AS OF JANUARY 20, 2024. DO YOUR OWN RESEARCH.