Everything You Need to Know About P/E Ratios

When it comes to stock market measures, none is more popular than the price-earnings ratio, a yardstick used to determine whether individual stocks (or the market as a whole) are cheap, reasonably priced, expensive or ridiculously overvalued. A P/E ratio essentially tells you how much investors are willing to pay for each dollar of a company’s profits. The P/E ratio is calculated by dividing a company’s stock price by its earnings, or in the case of the broad market, typically the value of Standard & Poor’s 500-stock index divided by its earnings. A low P/E signals a bargain, and a high P/E is a red flag. Simple, right?

Not so fast. There are many permutations of the P/E ratio. Getting the price is the easy part. But earnings? There are a lot of choices.

Earnings can be estimated, or forward-looking—a guess about what a company or the constituents of an index will earn over the current year or the coming four quarters.

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Here it gets complicated. If you’re talking about the P/E for the market, you can use top-down earnings forecasts (the best guess of Wall Street strategists, reflecting their view of big-picture economic factors). Or you could rely on bottom-up estimates—an average of the numbers crunched by analysts who follow each of the companies in the index. Analysts are often accused of falling in love with the stocks they follow, and bottom-up estimates tend to be more optimistic—resulting in a lower P/E—than top-down forecasts.

Or you could look at trailing earnings: results that have already been logged, typically for the past four quarters. The advantage of trailing earnings is that they’re already on the books; no guesswork is involved. The downside: They may be ancient history for a dynamic company or in a rapidly changing economic situation. If profits are growing, then trailing earnings will be lower than forward-looking earnings, and the trailing P/E will be higher.

Whether looking ahead or behind, investors have other choices to make when it comes to what to plug into the denominator of a P/E ratio. Some people prefer to use earnings that are reported in accordance with generally accepted accounting principles—so-called GAAP earnings. These are the earnings that are reported in a company’s official income statements. Other investors prefer operating earnings because they exclude expenses such as interest or taxes that aren’t directly related to a company’s widget-making, so you get a better picture of the profitability of the company’s core business.

The downside of using figures that aren’t based on GAAP, say critics, is that companies can get pretty creative about writing off expenses. “Cynics will tell you that operating earnings are earnings before bad stuff,” says Sam Stovall, chief equity strategist at Standard & Poor’s Capital IQ. GAAP earnings will usually give you a higher P/E value than will operating earnings.

A company’s profits can be volatile in any given year, for a host of reasons. You can smooth out the impact of outlier years by looking at earnings over the long term. Normalized earnings are averaged over a given period—typically three to five years but sometimes as long as ten. Normalizing earnings is especially useful for companies that are sensitive to swings in the economy, so you can measure profitability over a full economic cycle.

Probably the best-known method of normalizing earnings is one devised by Robert Shiller, a finance professor at Yale. Shiller, who won the Nobel Prize in economics last year, devised what’s known as the cyclically adjusted price-earnings ratio, or colloquially, the Shiller P/E. The CAPE takes the value of the S&P 500 and divides it by the average of ten years’ worth of reported earnings, adjusted for inflation. As the ratio rises above the long-term average of around 16, it signals that future stock returns will be less generous. (To calculate a CAPE ratio for individual stocks, visit www.caperatio.com.)

Recently, the CAPE has come under fire for overstating the risk in the market. Current CAPE values skew high, the argument goes, because the past ten-year-period captures the profit plunge during the Great Recession, the biggest ever.

Whatever components you use to calculate a P/E ratio, remember that P/Es are relative. Stocks in different industries or circumstances will have different P/Es, with mature, slow-growing businesses sporting modest P/Es and high-growth companies commanding much higher multiples. What is a high P/E for an energy company (recent average: 13, based on estimated earnings) could be low for a tech stock (recent average: 15), in the same way the P/E of a fast-growing biotech firm (75 for Regeneron Pharmaceuticals, for instance) would dwarf the multiple of an old-line pharmaceutical blue chip (14 for Pfizer). P/Es are only useful when comparing apples to apples, that is, a company to its peer group.

Ultimately, P/Es are a measure of optimism (or pessimism) about a company’s prospects or about the market overall. When investors are optimistic, whether because of the health of the economy, the certainty of a company’s potential for profits or some other reason, they often are willing to pay more for their share of corporate profits. (Of course, the converse is true as well.) When prices rise faster than earnings are growing, you’ll see P/Es increase. This P/E expansion is the reason bull markets can continue even after earnings growth has plateaued, while P/E contraction can knock prices down even when earnings continue to roll in.

Be careful when drawing conclusions by comparing current P/Es to historical values. Early earnings data may not be adjusted for inflation or accounting changes over the years. When Jim Paulsen, chief investment strategist at Wells Capital Management, started in the investment business in the 1980s, P/Es had longstanding valuation ranges that had been consistent for 100 years or more, providing a useful gauge of stock market value. “At the lower end of that range, you had a lot of confidence that stocks were cheap,” says Paulsen, and at the higher end, the opposite.

But that all changed after the 1987 stock market crash, he says. “When the market came back in the ’90s, it blew through the upper end of that range, never to return” to the older, lower range, he says. Since 1990, Paulson says, the average value of trailing P/Es has increased by almost 50%, from about 14 between 1870 and 1990 to about 20. “You can have a few years when P/E values are way out of bounds,” he says. “But can you have a quarter-century of that and say it’s somehow an outlier? Or do you have to wonder if something different is going on?” The debate isn’t merely philosophical. It makes all the difference in determining whether stocks are dangerously overpriced or worth buying.