Stock Investing: The Ultimate Guide to P/E Ratios

Hey guys, welcome to the next video. In this one, we will talk about the P/E Ratio, which stands for price-to-earnings ratio. The P/E Ratio is probably the most used ratio when it comes to stocks. It tells us very important information about the stock, probably one of the most important pieces of information, and it is how much a company makes, how much money it makes related to its market price. So again, how much the company makes, how much money it makes related to its market price. In other words, is the company making enough money to justify its price? That’s what the P/E Ratio deals with.

This is the formula: P/E ratio is current stock price. That’s the price you see if you look at the chart of that stock, so that’s the P, right? That’s the current price. And the E, this one stands for earnings per share, and the earnings per share means how much the company made after deducting all expenses, right? So it’s net income minus dividends. So again, price-to-earnings ratio is the current price of a stock divided by how much the company made.

Now here are two ways how you can look at it to understand it better. You can look at the P/E Ratio as how much you pay now to receive $1 of a company’s earnings in the future, right? How much you pay now to receive $1 of the earnings. So let me give you an example. Let’s say that the current stock price of a company, that’s the P, is 100 bucks. That’s how much one stock costs right now. Now let’s say that earnings per share, how much the company makes per one share, is 20 bucks, right? So that means that the P/E ratio in this case is five. So $5 is how much you pay now to receive $1 of the earnings, right? So now you pay five bucks, and in the next earnings, you get $1, then next year another dollar, then next earnings another dollar, and so on, right?

Or there’s another way how you can look at the P/E Ratio. Maybe this one will be easier for you to understand, and it’s how many years it will take the company to earn the money you paid for the stock. So if you look at the example, how many years it will take the company, it’s five years, right? It will take five years to make that 100 bucks you invested in it, right? So you paid 100 bucks for the company, and in 5 years, that’s five times the money you’ll get those 100 bucks you invested in this company, right? So that’s another way how you can look at it. You can imagine it any way you like, either this way or that way; both ways are correct. So it’s all up to you.

Now, obviously, as an investor, what you want is a low P/E. The lower the P/E, the better because the lower the P/E, the less you pay to receive that $1 of the earnings, right? The less time it takes to earn back that initial investment in that company. So let me give you another example. Let’s say that the price of a company dropped to 80 bucks. Let’s say that the earnings are still the same. In this case, the P/E is four, which is better than five, right? So the lower the P/E, the better.

Now let’s move on a bit. The P/E is a very good indicator of whether a stock is overpriced or not. There are a lot of beginner investors who look just at the P/E. I don’t really recommend doing that. The P/E is not a Holy Grail. There are many factors that can distort the P/E Ratio, so the stock could look very good or very bad. You always need to consider more information about the company, not just the P/E. You need to consider more information to get the complete picture. So, for example, you need to look at the P/B ratio, you need to look at the debt, how much in debt the company is, you need to consider the dividends or how the sector is doing overall. So those are things that you need to consider as well, not just the P/E. The P/E is not a Holy Grail. Even though it’s very useful, it’s not a thing that I would recommend using as a standalone ratio or standalone indicator. So don’t analyze stock using just the P/E.

This is the average P/E in the S&P 500 Index. Currently, it’s around 16, but this is the average. There are companies and sectors that are way above it, way below it. This is just sort of a middle ground standard. P/E differs between sectors, and that’s actually what I want to talk about right now. So let’s first talk about stocks with high P/E. Stocks with high P/E are usually stocks or sectors that are very popular. Those are stocks from fast-growing sectors. What comes to my mind as a good example is the technology sector. It’s a very popular sector; it’s fast-growing, and stocks here are quite overpriced, I would say, and they have very high P/E.

So the thing with those high P/E stocks is that their prices are inflated. The stock prices are inflated, and I wouldn’t have a problem with that, but they would need to have earnings to back it up, right? But usually, those overpriced companies don’t have earnings to back it up, to back the high price up, right? So why are investors willing to pay such high prices for such overpriced companies? If the P/E is that high, they pay such amounts of money because they believe in higher earnings in the future. They believe in a bright future; they believe that the overpriced company will make way more money than it’s making now. That’s why they are willing to pay such a high price. That’s why they’re willing to buy overpriced stocks with high P/E.

Here are some examples: Tesla or Netflix. Let me go to the fin screener and show you their P/E. So this is the fin website. Let me go to Tesla first. This is Tesla, TSLA, that’s the ticker, and in here, these are the details, the company details. P/E 16347. That’s insane. Nobody would be willing to pay such amounts of money if they didn’t believe that the earnings would rise dramatically in the future, right? That would be just insane. Investors that are investing in Tesla believe that earnings will grow dramatically, that’s why they are willing to buy Tesla for such a huge price, for such a huge P/E, right? Now Tesla, that’s, I would say, an extreme. Let’s now have a look at Netflix. The ticker is NFLX, that’s Netflix, and currently, Netflix has a P/E ratio of 32.8. This is still a very high P/E ratio. Remember, the average P/E ratio in the S&P 500 Index is 16, so this is double the number, right? So it’s a very high P/E. Again, why are investors buying this stock? They’re buying it because they believe that earnings will rise. They believe that earnings will rise dramatically to compensate for the high price they are paying for the stock right now, right?

So let me go back. Is it bad to buy a stock for a high P/E? It’s not bad if earnings pick up in the future, but we can’t be certain of this. We don’t see the future; we don’t know if earnings will pick up. We don’t know if the earnings of Netflix or Tesla will pick up in the future. That’s why I recommend buying stocks that have their P/E below 20, which means that they are currently not overpriced. That’s way safer than buying an overpriced stock for a high P/E and hoping that the earnings will rise in the future. That’s risky because we don’t know what will happen in the future. But if there’s a company that has a low P/E right now, then go for it. So yeah, as I was saying, P/E shows the current situation; it doesn’t show the future. It shows the current situation. It can change. The P/E can change depending on the future price of a stock and on the future earnings of a company.

Now let’s talk about stocks with low P/E. Those are usually stocks that are from sectors that are currently not popular. Those stocks are usually quite stable; there are often no surprises in those companies. What comes to my mind as good examples are stocks from the utility sector or stocks from the basic materials sector, right? Those sectors are not very popular, and those companies in those sectors are quite stable. So I think that those are good examples of sectors that have stocks with typically low P/E ratios.

Now, if you find a stock that has an extremely low P/E compared to the rest of the stocks in that sector, then most likely it’s not a Holy Grail, but you’ve probably found a stock that investors don’t believe in. It could be, for example, a company that made some money now, but in the future, investors don’t really believe the company will continue this way, making as much money as they made now, right? So if you found a stock with an extremely low P/E, then you should be cautious. There’s probably something that you overlooked. You most likely haven’t found a Holy Grail. If it’s looking too good to be true, then it’s probably not true.

Now, when you are using the fin screener to look for stocks you could potentially invest in, I suggest that you look for stocks that have their P/E below 20. I think currently, right now in the year 2022, this is sort of a rule of thumb which you can use. So the stocks that are above 20 are overpriced, and stocks that are below 20 are good to go. But this is just sort of a universal rule. As I was saying, all the sectors are different. There are sectors with typically high P/E ratios, and there are also sectors with typically low P/E ratios. So if, for example, you want to invest in the technology sector, then if you look for stocks with a P/E below 20, then you probably won’t find many, and you would need to lower your criteria and look, for example, for stocks that have a P/E below 25, right? Not 20, but 25. But the universal rule that I currently follow, and which I advise you to follow as well, is to look for stocks with a P/E below 20. Those are stocks that are not too overpriced, that are not too expensive.

Now, on a final note, this is what you should keep in mind. The P/E depends on a current market price and on current earnings. Both change over time. Market price changes every day, and earnings are also not a constant. So keep in mind that the P/E depends on both of these, and if you like a company which currently has a high P/E, then what I recommend is you wait. You wait until the P/E drops. Ideally, if it drops below 20. This could happen in two ways. So in order for the P/E to drop, let me write it down, what needs to happen is either the price drops. This is what lowers the P/E Ratio. Or earnings rise. Right, this also brings the P/E Ratio down. Keep that in mind as both price and earnings have an effect on the P/E Ratio.

All right, so I hope that I made it crystal clear. The P/E Ratio is definitely one of the most important ratios to look for, so I really hope you guys understood it well. If not, I recommend watching this video again and making sure that you completely understand what the P/E tells you. So yeah, that’s it for this video. Thanks for watching, and I’ll see you in the next one.