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How to Correctly Use Stock Indicators
Part 1: The Price-Earnings (P/E) Ratio
The price-earnings ratio (P/E ratio) is an indicator for evaluating joint-stock companies or stocks. It relates the current price to the company’s earnings per share. To help you better understand, I will illustrate the “theoretical” calculation of the P/E ratio using an example: If a stock is traded on the stock exchange at a price of 30 euros and the company achieves a profit of 3.00 euros per share in the current fiscal year, the P/E ratio is 10 (30/3.00).
When is a stock considered to be undervalued?
Occasionally, companies with a P/E ratio of less than 10 are considered to be undervalued. However, this is a very simplified view, as the P/E ratio varies from industry to industry. For example, stocks from the relatively slow-growing insurance industry are traded at a significantly lower P/E ratio than stocks from the fast-growing internet industry, such as Alphabet, Amazon, or Facebook. Therefore, you should primarily use the P/E ratio to compare companies within the same industry.
What if the company does not generate profits?
The P/E ratio has further weaknesses: companies that are experiencing strong growth may not generate any profits at all, but instead may be in the red due to high investments. A valuation based on the P/E ratio is not possible under these circumstances. Nevertheless, the stock may be promising if the investments lead to increasing revenues and profits in the future. In this case, investors can resort to other indicators, such as the price-to-sales ratio. Despite its weaknesses, the P/E ratio remains a very popular indicator. Due to its simplicity, it is suitable for historical comparison. This way, you can see, for example, whether a stock is currently more highly valued than it was one or ten years ago. A P/E ratio can also be calculated for stock indices such as the S&P 500. Here too, historical comparison allows conclusions to be drawn about whether a market is currently highly valued or not.
The facts:
- The P/E ratio is the most common of all stock indicators, also because of its simplicity.
- The P/E ratio is particularly suitable for historical comparisons and for comparisons within the same industry.
- Relying solely on the P/E ratio for stock selection can be misleading.
Our Conclusion:
The P/E ratio is a useful tool. However, you should never consider this indicator in isolation. Even companies with a P/E ratio of 3 can be hopeless. This is the case when the market rightly values the company so low due to its poor future prospects. Especially in such cases, it is important to take a look into the future. In most cases, the P/E ratio is calculated based on the profits that are forecasted for the future. This allows for better information on whether a company delivers sustainable profits.
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