P/E ratio definition

Question

According to Wikipedia, the Price-to-Earnings ratio has units of years. So a high P/E ratio, for example 80, would imply it would take 80 years to earn back the share price if earnings remained constant. Another way to look at it is the purchaser is paying 80$ for every Dollar of annual earnings.

Just based strictly on this definition, isn't a lower P/E ratio better? Because then you'd be paying much less for every Dollar of annual earnings or waiting a lot less years to earn back the share price.

Obviously this isn't true in the real world, but I'm really struggling with what P/E really means. Thanks.

Answer 1

Just based strictly on this definition, isn't a lower P/E ratio better?

When you buy a stock your are buying a claim on a company's future revenues.

P/E ratios are typically used to give a rough and ready estimate of how "reasonable" the stock price is for that cut of the revenues. An unusually high P/E ratio may indicate that the stock is overpriced, and an unusually low P/E ratio may indicate that the stock is a bargain. The catch is that the next decades earnings may be very different from this years earnings. If you are considering buying a stock with an unusually high P/E you have to ask yourself "Why do so many people think this company is going to earn a lot more in the future than it is earning today?" If you are thinking about buying a stock with an usually low P/E you have to ask yourself "Why do so many people think that this company is going to earn less in the future than it is earning today?"

Answer 2

So a high P/E ratio, for example 80, would imply it would take 80 years to earn back the share price if earnings remained constant

That's not completely accurate - you don't need to "earn back" what you pay for the stock, since it's not a "sunk cost". When you buy a stock, you have an asset that you can sell at any time for fair market value. Your "profit" comes from the increase in share price plus any dividends (which lowers share price, but that's another topic).

If you buy an 80 P/E share for $80, it pays a $1 dividend (distributing all of its earnings), it's price is still $80 and you sell it, you still earned $1 in profit - you don't have to keep the share for 80 years to profit.

Also, stocks with a high P/E ratio often are expected to increase earnings significantly in the future. An 80 P/E stock would have a return on equity of only 1.25% (which is very low) if earnings were held constant. The market might expect low earnings for a little while, but is expecting earnings to rise in the future.

Yes a lower P/E is generally "better" all things being equal, since the stock has a lower price for the same amount of earnings per share, but a "good" P/E ratio varies between industries.

Value investors often look heavily at P/E to do initial screenings, but will not stop there - they will use other metrics and deeper analysis to determine why the P/E is so low.

Imagine seeing two seemingly identical cars on a lot, but one is priced 20% lower. Obviously you would not just assume that it's a great deal - you would want to understand why it's priced lower. Is there some hidden mechanical problem? Does the other car have some subtle feature that adds 20% to its value? The same goes for stocks - P/E ratio can identify "cheaper" stocks, but you must determine if it's cheaper because the market is undervaluing it, or if it's cheaper for some other fundamental reason.