Let’s start with the Price-Earning Ratio. It is the relationship between the price of a share of a stock and the earnings per share of the same stock. A quick way to determine PE Ratio is to divide the price per share by earnings per share to get the PE Ratio. But there are other ways. But first let’s look at some examples.
If a company earns One dollar per share and the price of the stock is One dollar, then the PE ratio is 1. That would be a very unusual situation, as the price of a share normally is several times the earnings for the share.
Some more common examples:
If a company earns two dollars per share and the price of a share is $10, then the PE Ratio is 5.
If a company earns two dollars per share and the price of a share is $40, then the PE Ratio is 20.
A common way to consider what the PE Ratio represents is to see PE Ratio as the definition of a multiplier: When you pay $40 for a share of stock when the earnings per share is $2, you are paying “twenty times earnings.”
Use of PE Ratio
Some consider the PE Ratio to be barometer indicating whether the current price of the is too high relative to the company earnings. As a result, investors will sometimes see a high PE Ratio as meaning the stock price is too high, or “over-valued.” Some refrain from purchasing an over-valued stock. When a PE Ratio is lower, some investors will say the stock is “under-valued.” Some consider under-valued stock ripe for purchase.
To get a feel for what is common, let’s look at some averages from real data: the average PE Ratio of all the stocks in the S&P 500. (One must also recall that the companies listed as part of the S&P 500 changes over time.)
| Average PE for S&P 500 stocks during the decade… | |
| 1930s | 17.6 |
| 1940s | 11.2 |
| 1950s | 11.9 |
| 1960s | 17.9 |
| 1970s | 12.3 |
| 1980s | 12.0 |
| 1990s | 19.6 |
| 2000s | 20.2 |
| PE Ratio of the S&P 500 on December 31 for the years 1988 through 2017 | |
| Average | 23.2 |
| Maximum (2008) | 60.7 |
| Minimum (1988) | 11.69 |
| PE Ratio of the S&P 500 on January 1 for the years 1871 through 2019 | |
| Average | 15.7 |
| Maximum (2009) | 70.9 |
| Minimum (1918) | 5.7 |
As noted, one source puts the PE on December 31, 2008 at 60.7, and another sources puts January 1, 2009 PE at 70.9. Since the market was closed for the New Year’s holiday, one would think the number should be the same. As there are several ways to calculate PE Ratio, and as not all sources use the same methodology, numbers are not always exactly the same. But generally they’re close.
During times of economic stress, PE Ratios can swing wildly, as show in the following graph, where the maximum reached over 122:
There are two ways that PE Ratios can climb extremely high. One is if prices escalate tremendously higher than the earnings per share. The other is if earnings per share decline substantially relative to prices. Both can be considered dangerous for investors.
In general, current average PE Ratios are higher than in past decades. It is not difficult to find stocks nowadays with PE Ratios in the 20s, 30s, 40s, 50s, or even higher. Whether these stocks are appropriate for purchase is an individual decision. Some investors think that fast growing companies can afford high PEs. Others point to the concept of being over-valued.
Some resources on calculating PE Ratio.
Investopedia
https://www.investopedia.com/terms/p/price-earningsratio.asp
https://www.investopedia.com/ask/answers/070314/how-do-i-calculate-pe-ratio-company.asp
Corporate Finance Institute
https://corporatefinanceinstitute.com/resources/knowledge/valuation/price-earnings-ratio/
The Balance
https://www.thebalance.com/using-price-to-earnings-356427
So what do you do when you see high PE Ratios? Do you run or do you run in? Let me know here.
PE Ratio chart of S&P 500 courtesy MacroTrends.
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