One of the most commonly used metrics in fundamental stock analysis is the price-to-earnings ratio — P/E ratio for short. P/E ratios evaluate a company's profitability and provide clues as to whether the stock is undervalued. And when it comes to P/E ratios, the rules are the same as in golf: the lowest scores are the winners. But what is a low P/E ratio, and how are these rates used in stock analysis?
This article will discuss the price-to-earnings calculation, why it matters for stocks and how to use it properly when judging investment options.
What Exactly is a P/E Ratio?
Companies form for all sorts of different reasons. Some want to build more efficient technology; others want to sell goods to customers or other businesses. If you have an idea that can make someone's life easier, you likely have the basis for a business idea. Despite these drastically varying reasons for getting started, companies must adopt a particular goal once operations begin — profitability.
Earnings are at the core of many stock analysis tools because fewer metrics are more important than a company's ability to make money. Even the most charitable companies look for ways to improve profits, especially after going public and taking money from investors. This is because public markets reward profits, and investors value companies based on how efficiently they accrue.
The P/E ratio is one way investors value companies. The P/E rate shows how efficiently a company's profits are created since not every dollar of revenue turns into an equal dollar of profit. So, is P/E ratio high or low better? Consider the P/E ratio as the price you pay for a dollar of that company's earnings. A low P/E ratio means that investors spend less to "purchase" those dollars of profit when buying the stock.
For example, consider two companies in the same industry. Company A has a P/E ratio of 8, meaning that investors are getting a dollar profit for every eight they invest.
Company B has a P/E ratio of 24, a rate three times higher than Company A. In this scenario, Company B requires investors to pay more cash to achieve the same level of earnings, so Company A is considered "cheaper" to own.
The Significance of P/E Ratio in Stock Analysis
When faced with the question of is a P/E ratio high or low better, always choose stocks with low P/E rates, right?
In the words of Lee Corso, "Not so fast, my friend."
In a perfect world, we could fill our portfolios with only low P/E stocks, but these rates are relative across different industries.
P/E ratios are essential metrics for evaluating how cheap or expensive a particular stock is. Still, a stock with a P/E of 10 doesn't necessarily have a better chance at success than one with a P/E of 20. So far, some of the biggest winners of 2023 have been companies with sky-high P/E ratios, like NVIDIA Corp. (NASDAQ: NVDA) and Amazon.com Inc. (NASDAQ: AMZN).
The true significance of P/E ratios comes when comparing stocks across industries or sizes. For example, tech stocks like NVIDIA usually have higher P/E ratios than banks or utilities.
Large-cap companies with hefty profits often have lower P/E ratios than small caps that might be hungry for capital. So if someone asks, "Do you want a high or low P/E ratio?" the answer might only sometimes be low. A high P/E stock can still be a great buy and a low P/E stock can still be a loser.
How to Calculate P/E Ratio
One of the reasons the P/E ratio is used so frequently is that it's easy to calculate and interpret. You'll only need two variables to create the P/E ratio formula — the stock price and the company's earnings per share (EPS) numbers over the last four quarters.
First, take a look at the company's last four earnings reports. Public companies in the United States must report quarterly earnings, usually written in dollars of profit per share. If a company reported an EPS of 2, it earned $2 of profit for every share in circulation.
Take the last four EPS totals and add them together. For example, if a company's last four EPS reports showed 2.3, 3.1, 4.2 and 2.8, you'll add these together and get 12.4. Now look at the company stock price. Let's pretend this hypothetical stock has a share price of $100.
Here's how to calculate the P/E ratio:
100 / 12.4 = 8.06
The company has a P/E ratio of 8.06. That's good! Or is it? What is a high and low P/E ratio anyway?
As mentioned above, high or low can be relative depending on the asset class or stock sector.
Interpreting a Low P/E Ratio: What Does it Mean?
What is considered a low P/E ratio? Well, no one has a definitive answer, not even JPMorgan Chase. However, lower P/E ratios are preferred since low P/E means your dollars are more efficiently invested. But, of course, efficiency doesn't always guarantee better returns.
Factors Influencing Low P/E Ratios
Some factors that influence low P/E ratios include:
- Margins: Earnings are the revenue a business keeps after accounting for expenses. One way to measure how costs affect the business is through margins, which accounts for how deep a company needs to dig into revenue to pay for expenses. For example, a gross margin of 80% means that for every dollar of revenue, the company spends 20 cents toward the costs of goods sold.
- Economic performance: Since the P/E ratio is tied to the stock price, a broad recession that takes down index averages could also affect the P/E ratios of individual companies.
- Debt: Companies with high debt loads may not be able to convert as much revenue into profit if they have to service high-interest borrowing. Additionally, debt-burdened companies often see share prices suffer, which could drag down the P/E ratio.
Exploring the Benefits of Investing in Low P/E Ratio Stocks
Low P/E ratios can often mean an undervalued stock, but this isn't a uniform scenario. Many low P/E stocks have crashing share prices that deserve to be in the gutter. How can you tell if a low P/E ratio means a stock is undervalued? Here are a few tips for your analysis.
Tips for Identifying Promising Low P/E Ratio Stocks
To identify good low P/E ratio stocks, look for:
- P/E ratio below the industry average
- Reasonable debt load
- Low margins
- Accelerating profit growth
- No negative headlines or scandals
Comparing Low P/E Ratio Stocks to High P/E Ratio Stocks
Is a higher P/E ratio better? You might look at a sector like tech which has a P/E ratio approaching 40 and see stock prices rising faster than the market average. But this doesn't mean that high P/E stocks outperform low P/E ones. Consider the current market environment and trends, like how recent advances in artificial intelligence boost large tech stocks.
On the other hand, a low P/E ratio doesn't always mean an undervalued stock, either. If a major accounting scandal story breaks in a publicly-traded company, the share price will decline quickly. A low share price without a corresponding earnings decrease will show a low P/E stock, but obviously, a company with an accounting scandal won't go on your buy list.
To better understand P/E ratios and how they help investors, compare individual stocks to market averages, industry averages and the numbers of their direct competition. Is the stock you're researching higher than its peers and the market as a whole? If so, you might be looking at a company with too lofty a valuation.
Risks and Limitations of Low P/E Ratio Investing
Like all investment strategies and financial metrics, the P/E ratio has some downsides. Here are a few reasons you can't just go by the P/E ratio in stock analysis:
- Often well deserved: If a company suffers a setback or scandal, the P/E ratio won't tell you much about it. Many companies embroiled in controversy have low P/E rates since the stock price has fallen so precipitously.
- Backward-looking metric: The P/E ratio incorporates the last four quarters of earnings into its calculation, but it does nothing to project forward growth. Other metrics, like the PEG ratio, integrate forward-looking data in their formula.
- Varied across industries: A P/E ratio of 25 might be high for a bank but low for a retailer. Comparing companies across industries using P/E ratios might produce less useful information.
Case Studies: Successful Companies with Low P/E Ratios
Here are two examples of companies with very different P/E rates and why both are considered low despite the gap between them.
Value investors prefer stocks with low P/E ratios because they often look at stock sectors with older companies and established brands. With this in mind, let's look at two examples of successful low P/E stocks in two distinctly different industries. Let's start with the nation's largest bank: JPMorgan Chase and Co. (NYSE: JPM).
JPM is massive. Boasting a market cap of over $410 billion and over 12 million shares traded daily on average, the largest bank in the United States is also one of the biggest and most liquid stocks on public exchanges. With a P/E ratio of 10.37, the stock is also cheap compared to its peers like the Goldman Sachs Group Inc. (NYSE: GS).
JPM posted $4.10 EPS in its most recent report, beating analyst estimates by 69 cents. Since EPS has increased, the P/E ratio has been positively affected. Remember, the P/E ratio is an annual rate, so the last four quarterly EPS numbers are added together, and the stock price is divided by this total. In this instance, the yearly EPS total is 13.55. JPM's P/E ratio would then be calculated like this using today's stock price:
$140.47 / 13.55 = 10.37
Compared to the rest of the finance sector, this P/E ratio is lower than the current average, indicating that JPM stock is (slightly) cheaper than its peers.
The consumer staples sector is considered resistant to economic gyrations since these companies sell household products and goods that don't have elastic consumer demand. One of the most popular brands in this sector is The Proctor and Gamble Company (NYSE: PG).
Proctor and Gamble's shares have a P/E ratio of 25.53, which is more than double JPMorgan Chase's rate.
So is JPM stock a better buy than PG here?
Not necessarily! The consumer staples sector had an average P/E ratio of 25.91 last year, indicating that PG shares may be neither undervalued nor overvalued. Despite the gap, PG and JPM seem fairly valued compared to peers according to their respective P/E ratios.
How to Use the P/E Ratio to Make Informed Investment Decisions
Using the P/E ratio by itself likely won't reveal any investing secrets. But when used correctly (and in conjunction with other metrics), P/E ratios can help find undervalued companies.
First, always compare P/E rates within industries. Looking at the numbers between two competing utility companies will be far more informative than comparing a utility and a tech company. Next, use the P/E ratio and forward-looking metrics like the PEG ratio to understand the company's past better and projected future performance.
And finally, always dig deep to see why a particular company has a low P/E. Have scandals rocked the stock price? Are successful executives leaving the firm? Always make sure low P/E rates aren't hiding some unscrupulous information.
Don't Use Valuation Metrics in a Vacuum
P/E ratios are helpful but flawed metrics when it comes to evaluating stocks. Compared to industry peers or averages, finding low P/E stocks could mean the broader market has missed undervalued gems. But it could also mean a deeply troubled company with a stock facing the consequences from investors. Theoretically, a low P/E ratio is better than a high one, but understand the context of these numbers and use them appropriately.
Here are some frequently asked questions about a high or low P/E ratio:
What is considered a low P/E ratio?
It depends! Just seeing the rate attached to a stock doesn't give you enough information. You'll need to compare P/E ratios across the sector and perform due diligence to see if the stock price is suppressed for important reasons.
Is 10 a low P/E ratio?
Compared to the rates of broad indices like the S&P 500, 10 is a relatively low P/E ratio. However, this varies from sector to sector. For example, 10 would be considered in line with the industry average in the banking sector.
What is a good range for P/E ratio?
You'll need to consider the sector and outlook for the company you're researching before determining a good P/E ratio range. For practical reasons, some companies may have high stock prices, so an elevated P/E may not indicate an overvalued company.