Price-to-Earnings (PE) Ratio Explained: Does It Show the True Picture?

There are a bunch of metrics that you can use to determine if a stock is attractive from a valuation perspective. There are three broad categories of stock valuation techniques—the asset approach, income approach, and market approach. The price-to-earnings (PE) ratio is the most commonly used valuation metric.  

The PE multiple falls under the market approach of valuation. An extension of the PE multiple is the PEG (price-to-earnings-to-growth) multiple. In the PEG multiple, we standardize the PE multiple for growth for better comparability.

Like every ratio, the PE multiple has a numerator and a denominator. The numerator in the PE multiple is the current stock price, while the denominator is the EPS. You can also use the market capitalization as the numerator and the net income as the denominator. Both would deliver the same PE multiple. 

In simple terms, the PE multiple tells us how much money investors are willing to pay for a company for every dollar of its earnings. The PE multiple can be forward-looking like NTM (next-12-months) or backward-looking like LTM (last-12-months). In backward-looking PE multiples, we use the actual earnings. However, for forward-looking PE multiples, we use earnings estimates.

You can easily find PE multiples on websites like Yahoo Finance. Also, you can simply divide the stock price by the company’s earnings to determine its PE multiple. It can be debated whether you should use the GAAP earnings or the adjusted earnings. The general convention is to use the GAAP earnings.

However, there could be cases where adjusted earnings might reflect a better picture. For example, if a company incurs a major one-time gain, as in the case of sale of an asset or a major one-time loss like impairment of an asset, the adjusted earnings would portray a better picture.

There isn't a set definition of a low or high PE multiple. A low PE doesn't make a stock a buy and a high PE doesn't make it a sell. For example, Tesla trades at an NTM PE multiple of 182x, which is over 10x higher than Ford. This doesn't necessarily mean that Tesla stock is expensive and that Ford is cheap.

It's always better to look at the time series and cross-sectional analysis. If there's a divergence in a stock’s current PE multiple compared to what it has historically traded at, it might be worthwhile to explore more. The divergence could be due to multiple reasons.

The company’s growth outlook might have changed, markets might have rerated the stock (or the industry) as we saw with green energy companies in 2020, or it could be a case of mispricing of the stock.

The PE ratio is the most popular valuation metric, partially due to its simplicity and ease of understanding. Looking at the PE ratio, you can get a bird’s eye view of the valuation. However, you shouldn’t base an investment decision just on the PE multiple.

It's always advisable to look at some of the other metrics like the PEG ratio. That said, a stock’s PE multiple does matter. Looking at the broader markets, it has been proven that investors who buy the S&P 500 through an index or ETF at low PE multiples end up earning a higher return than investors who entered at a high PE multiple.

An ETF invests in a basket of securities that form part of the underlying index. So, the index's PE multiple is also the ETF's PE multiple. For example, towards the end of February, the S&P 500’s NTM PE multiple was 21.5x. All of the ETFs that track the index, including the SPDR S&P 500 ETF Trust (SPY), would have the same NTM PE multiple.