Price per Earnings (P/E): Is it useful?

Investing in the stock market can be tricky, and it really is for a lot of people. Many people think there is some witchcraft or higher power involved that will never let them have any chance of understanding it.

How many people develop ways to “beat” the stock market? Honestly, you never will beat it. You just hope that you’re on the right side of the fight and pick the winner (or loser) correctly.

A lot of people try to offer different ideas, and some seem to make a lot of sense. (Some do not; at least, not to me.)

One thing that many investors check is the Price per Earnings (P/E) figure. In fact, this is one of the most popular ratios (comparisons) used when evaluating a stock.

Is it the best?

What is the P/E? What does it mean?

The Price per Earnings (P/E) is exactly that. It compares the market (stock) value of the company to the after-tax earnings (bottom line Net Profit). For instance, if the market value of the company is $15 million, and they earned $2 million, then the Price per Earnings (P/E) is

P/E = (Market Price of Company) / (Earnings) = $15 million / $2 million = 7.5.

So this company is priced 7.5 times more than its earnings from last year.

What does this tell us?

By itself, it tells us that the company is profitable. Other than that, it does not tell us very much.

This figure is more useful when it is compared to the P/E of its competitors within its industry. A lower P/E indicates a lower price compared to its earnings. However, lower might indicate a lower quality company, too.

For the most part, you want to see that the P/E of your company is lower than its competitors, indicating a better value.

Be careful!

I have a few problems with the importance that so many investors place on the P/E value.

First, the P/E is not a bad thing, but it needs a story around it to explain it. There might be a very good reason that the P/E is really high. For instance, it could mean that it’s about to release a really cool invention. Maybe it has something that customers want, but it’s competitors do NOT have.

The other extreme is true, too. The P/E could be low, because it made earnings on a product last year, but the patent expired, and its competitors can make this now, which will lower the product’s price (and its earnings).

Second, the P/E measures something that happened, already. There is not always any guarantee that yesterday’s profit will carry into today or tomorrow.

Third, since a lot of people look at this value, it will be really hard to find a “hidden gem” by using this P/E ratio. Bargains are found when nobody else likes it, and it’s missing popularity causes the stock’s price to take a hit. The more people you have looking at a value, the smaller the chance that you will find a stock that is undervalued for the wrong reason. If the P/E is low, there is very likely a good reason. The stock might rise, still, but today’s low P/E is probably not a mass oversight.

Is the P/E Useful?

I think that the P/E is interesting to note. However, since it is not valuable by itself, even when it is paired with the values from its competitors, I think that it’s something that you may want to review, but you will need to research the company, still. Since ratios are meant to simplify things and explain a lot in a short period, I have to say that the P/E is way overrated.

Plus, I feel that too many people watch for this.

I am not a big fan of the P/E. So far, I haven’t met any investor that agrees with me.

It’s useful, but it’s not THAT useful.