One of the first financial ratios you will come across as an investor is the P/E Ratio. This number almost always appears when you search for a stock’s main information. Simply put, it's a popular ratio for getting a snapshot of a company’s value. It's also been advocated by Value Investors like Benjamin Graham and Joel Greenblatt. Are you interested in knowing why it's so important?

In this article from Hapi, we share the key features of this indicator, the history behind it, and how to use it in your future investments in the US Stock Market.

What is the P/E or Price to Earnings Ratio?

The P/E or Price to Earnings Ratio is a stock market indicator calculated using the following formula:

Trailing P/E Ratio = Price per share / Net earnings per share

Or in English, P/E Ratio (Trailing Twelve Months - TTM) = Price per Share / Earnings per Share (EPS)

This ratio relates what you pay for investing in a stock versus what you receive.

The price per share comes from the live stock quote available in reliable financial sources. In other words, it’s the price at which the stock is trading. The earnings per share, which are the company's income minus all expenses divided by the number of shares, can be found in the same sources under the name Earnings per Share (EPS). For example, if a stock has a price of $40 and an Earnings per Share (EPS) of $5, its P/E Ratio would be 8.

How to Interpret the P/E Ratio?

The P/E Ratio shows the price you pay for one dollar of earnings from a stock. For instance, if a company has a P/E of 20, one dollar of that company's earnings costs $20.

Another way to look at this number is as the number of years it will take to recover your investment. For example, hypothetically, it would take 20 years to recover your investment with a stock that has a P/E of 20.

Remember that by investing in a stock, you become a shareholder in the profits that the company generates. The earnings that this company makes will benefit you indirectly through increased interest from investors, leading to a rise in the stock's price.

How to Compare P/E Ratios of Different Stocks?

In general, when comparing two stocks with similar characteristics, a higher P/E indicates that the stock is more expensive. Likewise, a lower P/E suggests that the stock is cheaper.

However, this isn't entirely accurate when considering that different companies or sectors may have higher growth expectations for their earnings. Therefore, it's better to compare P/E ratios of companies against the average in their sector or their own P/E ratio in previous years. It's also good to consider the recent growth of the company's earnings.

What Factors Influence Higher or Lower P/E Ratios?

Some factors that lead to higher P/E ratios include:

Temporarily low earnings:

• Due to unexpected high expenses or a temporary drop in revenue, a company’s earnings over the past 12 months could be exceptionally low. If investors expect the company’s future profits to recover, the price will remain relatively stable, and the P/E will rise.
• This happened with many stocks throughout 2020 and 2021 when there was a drop in revenue due to the economic shutdown.

Expectations of exponential earnings growth:

• This is common among tech companies or growth stocks. These are companies whose sales grow consistently due to scalability, but they typically incur heavy expenses to continue growing. As a result, they may report low profits for a long time.
• Despite this, investor confidence in the company’s potential keeps the stock price high, and its P/E remains elevated.

If these optimistic future scenarios don’t materialize, the stock price could drop afterward. Conversely, there are other reasons why a P/E ratio might seem especially low:

The market is undervaluing the stock:

• When a P/E is significantly lower than that of other companies in the sector, it's because investors expect the company to perform poorly. However, this could be due to irrational short-term fears.
• If you are a long-term investor, buying a stock with a low P/E can be a great option. In fact, this is part of what Ben Graham, mentor to Warren Buffett, taught in his famous book The Intelligent Investor.

Temporarily high earnings:

• This is the opposite scenario and occurs when investors perceive that the current earnings level is unsustainable over time.
• In this case, expected earnings are lower than current ones, so there is less interest in including these stocks in major portfolios.

Are There Different Types of P/E Ratios?

There are two main indicators designed to "adjust" the P/E to a company’s expected future earnings growth. This can indicate whether a high P/E was due to better future performance or not. Since every investment depends on future performance, it is often necessary to review an indicator that looks ahead.

Forward P/E Ratio: Uses an estimate of future earnings instead of past figures. This indicator is useful for comparing current earnings with future earnings and helps provide a clearer picture of future performance without changes or other accounting adjustments.

If the Forward P/E is lower than the P/E (TTM), it means that earnings are expected to increase in the next period. It is calculated as follows:

Forward P/E = Price per share / Estimated net earnings per share for the next 12 months

Or in English

Forward P/E = Price per Share / Estimated Future Earnings per Share

P/E-Growth (PEG) Ratio: This is the P/E of a company divided by the earnings growth rate over a period of time (usually the next 1 to 3 years). The PEG Ratio adjusts the traditional P/E by accounting for the expected earnings growth rate in the future. This can help "adjust" for companies with a high growth rate and a high P/E Ratio. It was popularized in 1989 by Peter Lynch, one of the greatest investors of all time, in his book One Up on Wall Street.

Normally, a PEG of less than 1 could indicate that a stock is undervalued and a potential buy, while a PEG above 1 could indicate an overvalued stock. It is calculated as follows:

PEG Ratio = P/E Ratio / Earnings growth rate

Or in English

PEG Ratio = P/E Ratio / EPS Growth Rate

What Has Been the Historical P/E Ratio of the Major US Stock Indices?

Typically, the indicator used to analyze the P/E Ratio of the overall market is the Shiller P/E Ratio.

The earnings of companies listed on the Stock Exchange tend to fluctuate significantly in the short term due to the different stages of the economic cycle. For this reason, Nobel laureate economist Robert Shiller developed a modified version of the P/E Ratio called the Cyclically Adjusted Price-Earnings Ratio (CAPE). Today, it is also known as the Shiller Ratio for the S&P 500 and is calculated as follows:

Shiller PE Ratio =  S&P 500 price / Average earnings of the past 10 years for S&P 500 companies adjusted for inflation

As seen in the image, the current Shiller PE stands at 28.6, well below the last peak above 36. However, it is still 10% above the 20-year average, so caution is necessary when investing.

Let’s Review a Case Study Using All These Indicators

Advanced Micro Devices, Inc. (AMD) operates as a semiconductor company worldwide. The company has two segments: Computing and Graphics; and Software Development Services. Here are some of its main market indicators:

P/E = 27.29

Forward P/E = 13.04

PEG = 0.63

Using what we’ve covered in this article, we can make some simple interpretations of these numbers.

First, we can see that its P/E is close to the overall market average, so it’s not particularly expensive compared to other stocks. Additionally, against its own historical average of a P/E of 61, the stock could be undervalued.

Other positive factors include that the Forward P/E is much lower than the P/E, indicating high expectations for earnings growth. Similarly, with a PEG below 1, the expected growth in this company's earnings could make the stock an attractive buy.

However, these future growth expectations would need to materialize for the current interest in the stock to be justified.

Is the P/E Ratio the Most Important?

Each investor, with their risk profile and investment style, should define their process for selecting stocks and which ratios are most important. However, there are many reasons to believe the P/E Ratio is the most relevant.

The P/E Ratio is easy to find in all major financial sources. It’s an indicator you need to understand before studying more complex ratios. Additionally, it provides a starting point to determine whether a stock is undervalued or overvalued. From different perspectives, it’s a very important financial ratio, although it should be complemented with other indicators.

To make the most of this new knowledge, you can start investing quickly in the US Stock Market. Hapi, the investment app focused on Latin America, offers hundreds of stocks and cryptocurrencies. Are you still waiting to get started? The time is now! Open your account here.