There are three individual company factors that influence a stock’s performance. The first is the company’s earnings, the second is the expected future growth of those earnings. The third factor is how investors value both the current earnings and the expected growth of those earnings - which is called sentiment. A company’s financial reports tells us how well the business has just performed, however, it does not tell us anything about investors’ sentiment. One way to measure investors’ sentiment is the Price-to-Earnings ratio (P/E).
The P/E ratio can tell you a great deal about what investors think of a particular stock AND the sentiment of the overall stock market as well.
Components of the P/E Ratio
The P/E ratio for a stock is computed by dividing the share price by the company’s annual earnings per share. If a stock is trading at $40/share and its earnings per share are $2, then its P/E ratio is 20 ($40/$2).
Enthusiasm on the part of investors can lead to what’s called “P/E Expansion,” and conversely a lack of enthusiasm on the part of investors can result in “P/E Contraction.” P/E Expansion refers to when investors’ perceptions improve, and as a result, they are willing to pay more for a dollar’s worth of earnings.
On the other hand, P/E Contraction refers to a period when investors’ perceptions worsen, and as a result they are willing to pay less for a dollar’s worth of earnings. For example, if the average P/E ratio for stocks falls from 19 to 15 (21% decrease), while overall earnings remain unchanged, this is an example of “P/E Contraction.” In short, investors sentiment drives P/E ratios.
Different companies and different industry groups can trade at very different P/E ratios even if they are generating the same level of profit per share. In other words, two companies may both report earnings of $1 per share, but one stock will trade at $20/share while the other trades at $30/share. This can be due in part to several factors, like the quality of the earnings, the consistency of earnings, the expected future growth in earnings, expectations of the sector/industry, etc. If investors are excited about a particular company, the companies’ shares may be driven up and therefore its P/E ratio is driven up right along with the stock price. On the other end of the spectrum, if investors feel that future earnings look weak, its P/E ratio may deteriorate and remain low.
It's important to understand whether the current P/E ratio is presently relatively “high” or “low.” This can be quite challenging, although it can be done. There are three ways to assess a company’s P/E ratio:
Generally, if the current P/E is at the lower end of a company’s own historical P/E range, or if the company’s current P/E is below the average P/E of similar companies, the stock may be
Ideally, if a company is able to consistently grow its earnings, investors may become enthusiastic about the company’s long-term prospects and place a higher value on it and therefore it will trade with an above average P/E ratio. That being said, emotional buying and selling at the extremes can push stocks into overbought or oversold levels.
Conversely, a stock’s P/E ratio might be low simply because its future earnings prospects look weak. And this may or may not represent a good value at that price. The stock may not rebound in any meaningful way until investors perceive there to be some catalyst to the company’s earnings. This can create a “value trap,” where a stock looks cheap, but its cheap for a reason.
As a stock’s price rises, investors need to pay close attention when a stock gets bid up to an excessively high P/E level. In the heat of a bull market, it is not uncommon to find “hot” stocks trading at a P/E of 50 or more. While this can go on for some time, eventually a stock’s price and P/E ratio comes down when its future prospects are more in line with the overall market. When this happens, the ensuing price decline can be swift and painful.
Exceptionally low or high P/E ratios can highlight potential opportunities or dangers. Understanding what is driving a stocks P/E ratio is important, as it is not uncommon for a stock or the overall stock market to have an unusually high or low P/E ratio for an extended period of time due to the above factors.
And there you have it, now you understand how the P/E ratio can be used to determine the sentiment for an individual company as well as the overall market.
-Paul R. Rossi, CFA