The PE -- or price to earnings -- ratio is one of the most essential metrics to use when evaluating a stock for investment. There is no concrete answer regarding whether a higher or lower PE ratio is more desirable; rather potential positives and negatives exist in either case. Once an investor identifies a relatively high or low PE ratio, it is important for that investor to do further research to determine the cause.
The price to earnings ratio is the ratio comparing a stock price to a company’s earnings per share. For example, if a stock is trading at $50 per share and the company earnings are $5 per share, the PE ratio is $50 to $5 or 10. PE ratios are commonly expressed as a single number rather than the two separate numbers used to compute the ratio.
Low PE Ratio
A low PE ratio is attractive to value investors because it is a sign that a stock may be undervalued. On the other hand, some investors are wary of low PE ratios because they can signify that a stock is not attractive to the market. Essentially, some investors screen for bargains by looking for low PE ratios, while others question why the stock is trading at such an apparently attractive price in the first place.
High PE Ratio
A high PE ratio signifies that investors are paying a premium for a stock in relation to company earnings. A stock with a high PE ratio is said to be overvalued by some market analysts. However, the high PE ratio can also be a sign of strength, as it means that investors are willing to pay a premium for a stock. For instance, if investors are optimistic about a company’s future growth, demand for the stock will increase and consequently the PE ratio will also rise.
When evaluating a stock’s PE ratio, compare it to the PE ratios of similar stocks. Companies in different sectors have varying operational and business structures; as a result, the average PE ratio for a stock varies depending on its market sector. When judging whether a PE ratio is high or low for any stock, compare the stock to others in the same sector rather than to the market in general.