What is the PE ratio and how do I use it?
Updated: Sep 19
What is it:
The PE ratio measures how “expensive” a stock is by dividing its price by the earnings per share produced by the company.
How do I use it:
the PE metric can gauge if a stock is broadly cheap or expensive - but investors do well to remember that cheap stocks can keep falling and expensive stock can keep rallying. At the same time, it is often interesting to study stocks when PE reaches historic highs or lows.
What is the PE ratio?
The PE ratio is the most widely used valuation metric in equity space. It applies to single stocks and by extension to equity indexes, and works well for most industries with some relevant exceptions.
The ratio is calculated as the ratio between the share price and the earnings per share. The latter can be trailing earnings or forward earnings.
Trailing means that these are real earnings that the company has produced in the last 12m or last fiscal year. Forward refers to the expected earnings per share of a company, based on the mean/median earnings estimated by the analysts that cover the company.
The two measures each have their own drawbacks. Trailing earnings are backward looking, and forward earnings are usually just a lagging indicator based on market performance.
How do I use the PE ratio?
The chart below shows the trailing PE for IBM in the last 5 years. PE is a relatively range bound measure, hence studying the local peaks and troughs can lead to some interesting conclusions. One can already see that if the PE is in the top of range in the upper chart, the price is likely to fall subsequently in the lower chart - and vice versa.
In order to find interesting stocks based on low or high PE you can use the cheap_valuation and expensive_valuation tags to identify cases in which valuations seem to have reached extreme levels.