The Price to Earnings, or P/E ratio, is one of the most basic ways to try and figure out if a stock is generally cheap.
The logic behind the P/E ratio is quite simple. The equation for the P/E ratio is simply Price / Earnings. A low P/E is generally considered better than a high P/E. A low P/E can happen one of two ways: either a low price, high earnings, or both.
Because the main goal of a business is to turn a profit (earnings is just another word for profits), Wall Street likes when a company has good earnings. Investors should also like lots of earnings, and earnings growth.
The problem is that Wall Street can overvalue earnings to the point where a price of a stock will go so high that future gains would require continued exceptional earnings performance from the company. It’s safe to say that businesses can’t maintain top tiers of performance forever, we haven’t seen one so far.
That’s where the P/E ratio comes into play. A good P/E ratio combined with great growth numbers indicates a stock that hasn’t run up irrationally in price– yet.
As investors starting out in individual stocks, the Price to Earnings ratio can be a fantastic starting point. What’s not immediately clear is what makes a good P/E ratio. While there are general rules of thumb, the ratio itself does require some context. You absolutely do NOT want to buy a stock simply because of one ratio. But it is very helpful to understand when you see a good P/E ratio vs. when you don’t.
That’s what this blog post will attempt to achieve. A definition to the common question: what is a good P/E ratio. But first, a quick overview of intrinsic value— which is what the P/E ratio is ultimately trying to determine (and its relation to current market price).
How the P/E Ratio and Intrinsic Value are Related
Buying a stock with a better chance of having higher than average gains requires buying stocks that are cheap compared to their intrinsic value. Let me answer this question from a VTI book client and podcast listener:
I listen to your podcast daily and have recently bought your book, and have been killing myself trying to figure out one question: how do I find the intrinsic value of a stock? I know this is a “best guess” and only an estimate, but still something I would like to have an understanding of.
If you could please help, I would greatly appreciate it!
The thing about intrinsic value is that there’s an art and a science to it.
The science part is clear.
We must use the financial data for each company, and interpret those numbers to make a decision. Compare them to the numbers in the stock market (market cap, etc), and determine whether a good price or not.
The problem with this is that it’s not 100% an exact science.
For one, everyone’s preferred numbers to calculate intrinsic value is going to be different. It is. Just look at the wild differences in valuations (P/E, etc) between the stocks in the market out there.
Secondly, it’s not smart to set an exact number for intrinsic value (this is my opinion). Let me explain why.
Real intrinsic value of a company is always changing.
Take the case where a company gets into a bunch of debt even while the earnings trend stays the same. Same numbers everywhere else– but the real intrinsic value is less because investors have to take on more risk.
Say interest rates increase. Take a business that has much less debt than its competitors. Increasing interest rates likely aren’t hurting their real intrinsic value as much as the rest of the market.
Here’s another example.
Take a business that is cyclical (does very well when the economy is booming, and vice versa). Its real intrinisc value fluctuates with the economy– much more so than non-cyclical stocks.
And on and on and on.
This makes it very difficult to assign an exact number for intrinisc value. Billionaire value investors like Warren Buffett and Seth Klarman agree that intrinisc value should be an approximation within a range– and not a prediction of a single number.
Consider that a lot of intrinsic value formulas depend on projections as well (such as interest rates, inflation, future earnings estimates, etc). It’s just another instance of a single intrinsic value number being flimsy.
Now. The solution here becomes the art component of calculating a stock’s intrinsic value.
Calculating the “Art” of Intrinsic Value
We want to calculate an estimate based on a general range.
I interpret that as making sure a stock is generally undervalued, all across the board. Buying generally undervalued stocks with give us a general advantage over the average, and over time through enough diversification, it’s likely that our performance will also be generally better.
The way I do this is through the Value Trap Indicator. Here’s how.
When I buy a stock, I want all systems go. I want each of my stocks to fall in a general range of acceptablility across all aspects of the financials.
That way there’s no cracks. No weaknesses being covered up (unlike Enron, whose weaknesses actually showed up on the balance sheet but everyone ignored it).
So if we can agree that intrinsic value can’t be specified but instead must be approximated, it only makes sense that the P/E ratio, which is used to assist in determining intrinsic value should also be approximated and not constricted to a specific value or even predefined range.
Examples of a Good P/E Ratio
As an example, I want a stock to have a P/E under 25. I’d prefer it to be under 15, but it’s ok if not.
It’s also ok if the stock is like P/E = 27.
That’s not much different than P/E = 24– if you think about it.
Say that a stock has great metrics all across the board, but the P/E is just barely higher than 25. I’m probably still buying, because the P/E of 27 says there’s enough earnings compared to what I’m paying (price or market cap), even though not exactly meeting a numbers requirement.
But the higher away from 25 that the P/E goes, the less and less I’ll want to buy it. A range like that should mean keeping away from stocks like a P/E of 50, even if the rest of the financials are stellar.
That’s the idea behind mixing art and science.
You buy stocks that are in enough of a range where you’re generally buying at or with a discount to intrinsic value (margin of safety). And unlike most of the rest of Wall Street, doing this with metrics from all 3 financial statements, so the complete picture is being considered.
That’s a powerful way to structure a portfolio. Not through shaky projections or exact estimates…
But on a principle that a group of stocks generally bought at a general discount will generally outperform the market. I love betting on averages (tipping the odds in my favor) rather than on single outcomes. You probably should too, especially when it comes to using the P/E ratio.