Valuing Investments: Price-Earnings Ratio

Joel Dresang: Dave, investors need a sense of value for what they buy and what they own. They have many tools available to do that. The most common for valuing stocks is the price-earnings ratio. Let’s talk about that.

Dave Sandstrom: Joel, there are many different ways that we can try to value stocks. We look at the price-earnings ratio, which compares prices to earnings. You can compare prices to sales of a company, prices to the book value of the company, prices to the cash flow of the company. But I think the average investor is most comfortable with earnings.

Joel: Let’s do a definition. Price-to-earnings: That the price of the stock divided by the earnings per share. A stock is selling for $70, and earnings per share are $7. So that would be a P/E ratio of 10. What does that tell us?

Dave: Well, I think what it’s trying to tell you, Joel, and what we can use that information for, is give us an approximation of how much does it cost to get $1 worth of earnings from that company, or from a broader index, if that’s what we’re looking at.

I think it’s important to keep in mind that P/E ratios, as they apply to individual companies, can be quite volatile. And I’d be careful using that as an absolute tool for purchasing.

I think it’s more valuable to the average investor to look at the broad indexes, let’s say the S&P 500, and look at the P/E ratio for the entire index.

Joel: And it gets confusing, because there are a variety of P/Es. Can you explain that?

Dave: Sure, Joel. There are quite a few. I think that there’s three that you’ll see most commonly.

1. One is the trailing P/E, which looks at earnings over the prior 12 months.
2. You have a forward P/E that tries to look into the future, with a projection of what earnings are going to be in the next 12 months.
3. And then there’s the CAPE, which is the cyclically adjusted price-earnings ratio that looks back 10 years and takes an average of earnings and uses that number.

Joel: So how do you know which one to use?

Dave: Well, I think they all have some pros and cons.

The trailing 12, at least you’re getting information that you know occurred, from the earnings standpoint. So a little bit accurate number there.

I kind of prefer the forward-looking P/E because I’d like to know what’s coming, what’s going to happen in the future. Although, you have to take that with a grain of salt because it is a projection.

The CAPE index looks back at 10 years’ worth of information, and if you’re gathering a one-off event, like the financial crisis, that might have an impact on that number that might render it a little less useful.

Joel: Okay, so you get the P/E for the broad market, the S&P 500. What do you do with that?

Dave: I think that the best way we can use that is to look at historical averages. So, looking back, let’s say, on a 20-year historical average of the S&P 500, is the current P/E, or the trailing P/E even, is it higher than that? Is it lower than that?

It kind of gives us a little bit of guidance as to, “Are stocks overall expensive right now? Or, maybe are they inexpensive?”

Joel: So you look at historical averages as a context for the P/E. What about interest rates?

Dave: Interest rates are a very important part of that valuation.

When you buy a stock or stocks, you’re participating in the future earnings of that company or those companies. So you need to discount those earnings back to the present value to determine what you’re getting. And you use an interest rate to do so.

So, when we’re in a low interest rate environment, that supports, typically, a higher P/E ratio.

Joel: So, we are in a low interest rate environment, and the P/E for the S&P 500 has been high compared to historical averages. Where does that put us?

Dave: I think you never use it as an absolute – to get into the market or get out of the market. I think it’s always important to make sure that we have some stocks in our portfolio in a balanced situation.

But when we’re in a situation where prices are elevated, as they might be right now, look ahead to say, “Well, maybe I have some income needs coming up, or I have a large purchase, a new roof, a new car.” When we’re in these elevated P/E situations, it might be a good idea to take some of that profit.

Dave Sandstrom is vice president and an advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Jason Scuglik

(initially posted Sept. 26, 2017)