P/E ratio is one of the valuation metrics that you will see on a stock market chart. You can use P/E to see if shares and ETFs are overpriced. By the end of this post, you’ll flinch whenever you see a value over 25.
What is P/E Ratio?
It simply means “price to earnings ratio”. You can work it out by taking the price of the share (or ETF) and dividing it by the earnings of the company (or the fund) in a year. Another way of thinking about it is that it’s the number of years it takes for a company to have enough money to buy all of its shares at market value. I prefer to think of it that way because it gives you perspective.
If a company has a P/E ratio of 15, it will take 15 years before its earnings at the last report’s rate are enough for it to have paid itself off.
Like most valuation metrics, it has its limits. For example, some assets of a company (like property or heavy plant or whatever) have their own intrinsic values that aren’t easy to account for. It’s also very short term, as it’s based on the last quarter’s accounts. If something unexpected happens, like Covid-19, the p/e ratios will be artificially boosted for many companies. This is because earnings will drop faster than share prices, as it takes time for shares to be sold. Most shareholders would sell off after seeing the numbers in the report.
What is a good P/E ratio?
The lower the better, without going negative!
In theory, a buyer would want to pick up the best source of income (earnings) for the lowest price. This would mean that a low P/E would be brilliant for buying a share at, assuming that there were no other alarms. Typically, you will struggle to buy shares or funds with a P/E ratio much lower than 12.
Fake news – how a good p/e might be misleading
Because of the way it’s worked out, a good p/e might happen because a company has a freakishly good quarter. A company might also sell off one of its capital assets, like a factory or the manufacturing equipment it uses to make its products, and declare these as earnings – depending on what the asset is and what the company does for business. This can make a company look more attractive by giving it a lower P/E temporarily, which would encourage investors to buy the shares. When lots of investors buy shares, share prices rise – but the results might not be repeatable next quarter or year.
What is a bad P/E ratio?
A bad P/E ratio would be one that’s so high there’s no way a company can grow its earnings fast enough for the ratio to correct itself. Benjamin Graham’s The Intelligent Investor sets a target buying ratio of up to 25, with 15 being the supposed middle point between highs and lows. Although Graham was writing back in the 1960s and 1970s, his data was several decades old and there’s no reason why ratios should change. If this is true, shares are generally overvalued when you’re buying them at a P/E over 25, unless you think that any losses are temporary or that the earnings are rapidly growing.
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Why a bad P/E isn’t everything
Before you decide to sell off all your investments because they’re at a P/E of 30 and you can buy shares with a lower ratio, I’d better point something out.
P/E ratio is based on the near past. If a company is rapidly growing its earnings, maybe by embarking on a new business venture or has just bought another subsidiary company, the ratio might well be misleading. The new income stream won’t have taken effect but the cash will have been spent on it, which means that the earnings might well have a loss on them from the company’s investment. Fortunately, if the company has gained a new income stream, this should correct itself quite quickly over the next 12 months!
Does this work for funds, too?
ETFs and other collective investments in shares will have a P/E ratio, as will REITs.
Here’s the Vanguard World All-Cap ETF, as displayed on Vanguard’s own website. I’ve shown you the P/E score on the picture.
We can see that the P/E – averaged out across all the shares in this fund – is just below Mr. Graham’s magic 25. It’s higher than we’d expect, given Covid-19 at the time of writing, but it’s not unreasonably priced.
This is not a recommendation to buy this fund – I’m just using it as an example! For the sake of transparency, I openly declare that I don’t buy into this fund. I hold no position on it and I make no money from Vanguard for showing it.
Is P/E all I need to know about investing?
As described above, P/E can be misleading. If you invest based entirely on p/e ratios, you’re going to have a bad time. It’s just one of several valuation metrics you can use to check if something is over or under valued.
Other good ones include cost to book ratio and its cousin, cost to tangible book. These combine really well with p/e ratio when you’re trying your hand at value investing.
How I use P/E ratios in my financial independence campaign
If you look at my 2021 campaign plan, you’ll see that I dabble a little in single investments. I use P/E to spot opportunity buys at low values. I also use it to choose what’s going into my regular investment pot, and it helped me pick the three REITs that are currently in my ISA.
As I’m trying to diversify across asset classes, I do consider P/E when I have “spare” money left over from my budget. If P/E of my favourite funds are looking high, I can buy something else that month. If they’re a tad on the low side, I’m going to spend more money on my equities. Don’t get me wrong: I still make the monthly contributions, I just choose what to do with the leftover odd change.
