How to Use the Price Earning (P/E) Ratio

The Price Earning ratio (P/E) is very popular in investing. It is defined as the current Price divided by Earnings and it’s supposed to tell you whether the stock is cheap or not. A low P/E ratio means that the company has lots of earnings relative to its share price.

The problem with the P/E ratio is that it can be used to justify anyone’s analysis. A low P/E ratio is easily explained as high earnings for a low buy-in price, while high P/E ratios are a characteristic of companies that are investing in growth and foregoing current earnings. Both of those things can be true, but they can also not apply to the stock you’re looking at. It could be that the reason for the high P/E ratio is not because the company is a high growth company, it might be that it’s just not earning any money because it’s products aren’t selling, or management doesn’t know what they’re doing. If the P/E ratio is the only thing you’re looking at, there’s a high probability you will be making a mistake, or at least an uninformed decision.

If you are going to look at the P/E ratio to make an investment decision there is only way to make sure that you evaluate it correctly. The P/E ratio of the company you are evaluating is useful when you compare it to the P/E ratios of other companies in the same industry. It is this relative comparison of P/E ratios that will tell you whether it is high or low. For instance, if you look at 10 utility companies that have PE ratios between 12 and 35, you can tell that the one with the lower P/E ratio has higher earnings relative to it’s share price. Comparing that same utility company to a software company with a P/E ratio of 50 does not tell you anything about either company, so you shouldn’t do that.

Screening Stocks With the P/E Ratio

The P/E ratio is not the most useful metric to use to screen companies by itself, but if you want to use it in that capacity you can do so by combining it with other screening criteria. For you to be able to derive any meaning from the P/E ratio you must use the following criteria in your screener:

1. Your P/E ratio should be below 40.
   Any P/E ratio above 40 is just not worth your time, unless it’s a fluke and it’s only had that value in the current year and there were unusual circumstances for the company that won’t be repeated. But the fact that you would have to look at multiple years and dig through previous year’s statements to find out why it is currently above 40 will make this a slower process for something that you’re trying to do quickly.
2. Industry
   Select an industry to look at in your screener. It doesn’t matter which one you choose, but choose only one. You can do this for every industry in the market, but the screener must be done with only one industry at a time so that you are still comparing relevant P/E ratios.
3. Market Cap
   Market Cap is one of the easiest screeners to apply, and in this instance it’s an important one. Small companies, companies that have recently had an IPO, and generally anything with a market cap below $500 million is risky if all you are doing is looking at P/E ratios. This is because if a small company also has small earnings it is much more susceptible to market forces impacting it’s ability to survive. Small companies with small earnings may also have a harder time getting financing, or absorbing a shock to it’s business.

Once you have the results from your screener you’ll have to look for the companies with the lower P/E ratios on the list, and those will be the ones you should focus your attention on. By itself this analysis is incomplete and it could even be dangerous. If the whole industry is in decline and this is the only thing you looked at you may be able to find the company in the industry with the lowest P/E ratio, but that doesn’t mean that it’s a good one. Generally speaking a low P/E ratio will tell you that the company doesn’t have a blatant issue with earnings, but it won’t tell you whether the company is healthy either. For those reasons this screener should be used to eliminate companies with abnormally high P/E ratios relative to other companies in the same industry. To make the P/E ratio screener more helpful you can combine it with the screeners we discussed in our 4 Things to Quickly Filter Stocks blog post.