What is a Good P/E Ratio? Top Factors to Consider When Investing
The price-to-earnings ratio is one of the most crucial ratios used by investors to determine whether or not a stock is overvalued, fairly valued, or even undervalued.
- But how exactly do investors analyze the P/E ratio?
- And what makes a good P/E ratio?
In this article, we’ll carefully analyze what factors influence the analysis of the price-to-earnings ratio and its importance when picking stocks and deciding whether or not to invest in them.
Importance of the P/E Ratio
The P/E ratio is the main financial ratio investors use when valuing a stock. It allows them to quickly compare the current price of the stock or market cap relative to the company’s earnings.
Over the long term, stock prices may change for different reasons and tend to reflect the company’s earnings. Determining whether or not a stock is worth investing in requires you to analyze the P/E ratio and understand precisely how much you are paying for the company’s earnings.
4 Factors to Consider When Evaluating the P/E Ratio
Earnings Growth
To invest successfully, you need to find stocks whose earnings are increasing. As a rule of thumb, the higher the expected growth of the company’s earnings, the higher its price-to-earnings ratio will be.
This reflects that investors are willing to pay a lot more for a company whose earnings are expected to increase, increasing its valuation.
Earnings Consistency
A consistently profitable company that has increased its earnings over time usually has a higher P/E ratio to reflect that.
This is another factor to consider when evaluating the price-to-earnings ratio.
Competitive Advantage
Another factor that investors always consider is the company’s competitive advantage. As Warren Buffett puts it, the moat.
Companies that have competitive advantages over their competitors usually demand a higher valuation. This higher valuation, or premium, relative to their peers can be easily identified in their P/E ratios.
Because these companies are safer to invest in, their price-to-earnings ratio tends to be higher. Be sure always to consider this when determining what a good P/E ratio is.
Average Price-to-Earnings
While investors can analyze the price-to-earnings ratio intrinsically and based on the company, other ways exist.
This approach involves comparing a company’s P/E ratio with its industry average or some of its competitors. You can also compare the P/E ratio of a stock with the current index average P/E ratio.
These comparisons may not be sufficient to make an investment decision. Comparing and determining how a stock might be overvalued relative to its industry average or other companies in the index is crucial.
Using spreadsheets or a good stock tracking software can help get you a P/E ratio much faster than doing the work manually.
Determining What is a Good Price-to-Earnings
Here is a framework to help you identify and analyze a stock price-to-earnings ratio:
P/E Ratio Under 5
Stocks with a P/E ratio under 5 are often considered deep-value stocks.
These stocks will often be risky, and the company may be approaching bankruptcy. However, some stocks with extremely low P/E ratios are worth considering.
P/E Ratio between 5 and 10
Companies with a price-to-earnings between 5 and 10 are often considered value stocks.
This includes companies that have been negatively impacted by recent earnings or are not expected to grow their earnings soon.
P/E Ratio between 10 and 15
Companies with a price-to-earnings between 10 and 15 can be considered value stocks and fairly valued, and most of these companies tend to have consistent earnings.
However, stocks with P/E ratios in this range usually will have higher-than-expected earnings growth, and those are the stocks you should look for.
P/E Ratio between 15 and 20
Stocks with a P/E ratio in this range are often either well-established companies with a competitive advantage and consistent earnings that are not expected to grow a lot or some growth stocks that had lower than expected growth.
P/E Ratio between 20 and 25
Stocks with a P/E ratio of 20 to 25 are often considered growth stocks favored by other investors, as well as some well-established large caps expected to grow moderately.
P/E Ratio above 25
Growth stocks will often have P/E ratios above 25 or, in some cases, are high-quality companies with a solid competitive advantage. Since these companies are expected to grow earnings faster, the P/E ratio tends to be higher.
Trailing vs. Forward P/E Ratio
Investors should also know the differences between the trailing and the forward P/E ratio. The trailing P/E represents the P/E ratio of the stock based on the earnings over the last 12 months, while the forward P/E ratio is calculated based on the expected next 12 months.
When determining a good P/E ratio, investors should focus more on the forward P/E ratio because it gives you more information about the future earnings of the company and what the valuation will be.
So, What is a Good P/E Ratio?
There is no clear answer, but investors need to use the P/E ratio to determine whether or not it accurately reflects the company’s valuation. A higher P/E ratio isn’t necessarily bad, and the same way that a low P/E ratio isn’t good.
Each stock is a different company, requiring you to analyze it individually and consider whether or not the P/E ratio and valuation make sense for that particular company.
About the Author: Value of Stocks is dedicated to providing accurate and informative articles to help educate individuals on various financial topics, from investing to trading and retirement planning.