Everyone loves a bargain, so a stock with a low price compared to its earnings seems like it would be a good deal. If you believe the market is efficient, though, then the stock price reflects what other investors think about the stock. A stock with a high price-earnings ratio, or P/E, suggests that investors like the company’s prospects for growth, while a lower P/E indicates a value.
The P/E is the share price of a company’s stock divided by the profits that the company earns in a year. For example, if a stock sells for $15 and the company earned 60 cents per share over the last year, the P/E is 15 divided by 0.60, which is 25. The P/E will vary over time as the stock price fluctuates and the company earns more or less profit.
Growth vs. Value
If a company has a high P/E, investors are paying a higher price for the stock compared to its earnings. Investors are willing to drive up the price for the stock because they believe the company has good growth prospects -- that it will make more profit in the future. If a company has a lower P/E, you get more earnings for your investment. This makes a low-P/E stock a good value, but it can also simply indicate that investors aren’t very confident about the company’s prospects.
Companies in high-growth industries, like telecommunications and biotechnology, are by their nature likely to have higher price-earnings ratios than companies whose returns tend to be more steady and stable, such as mining operations. To figure out whether a stock is priced well, you must be careful to compare apples to apples. A utility company may have a lower P/E than a cellphone manufacturer, but that doesn’t necessarily mean it’s a good deal. If you compare the utility’s P/E to that of other utilities, you’ll get a better understanding of where it stands within its own industry.
The stock price reflects everything that investors know about a company and where they think it's headed. For this reason, it’s important not to look at the P/E -- or any other single factor, for that matter -- in isolation. Instead, you must consider the entire picture of what you know about a company, its management and its prospects. A low P/E could mean that investors aren’t giving the company enough credit, but it could simply reflect that the company is poorly managed or an event that might have a negative impact is imminent.