A Note about Price-to-Earnings Ratio

What is more expensive, Google at $553 per share or Amazon at $127 per share? If your answer was Google, you definitely should read this post. The price per share of Google is most definitely higher than Amazon, but there are much better ways to compare their value. The price of a stock and its value are not necessarily the same. Adam did a great job of explaining Price-to-Book Value in a previous post and I will attempt to explain another way to value a company's stock, the Price-to-Earnings Ratio.

Earnings are the mother's milk of stocks and the Price-to-Earnings Ratio is a method of using earnings per share (EPS) to value a stock. Price-to-Earnings Ratio is calculated as follows:

market value of a share / earnings per share

The Price-to-Earnings Ratio (P/E) is sometimes referred to as the "multiple", because it shows how much investors are willing to pay for each dollar of earnings. If a company were currently trading at a multiple (P/E) of 10, the interpretation is that an investor is willing to pay $10 for $1 of current earnings.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects. - source Investopedia

Earnings growth should also be considered when valuing a stock. Another ratio has been devised called the PEG:

P/E Ratio / EPS Growth % = PEG ratio

Always try to have a margin of safety in your investments. Not only does it help on the downside but low P/E stocks have substantially outperformed high P/E stocks. PMC tries to find stocks trading at low P/Es and low PEG ratios. A company growing 5% faster than the rest of the market with a P/E twice that of the market will have to continue growing for another 14 years at that rate before the shareholder is fairly compensated. A problem that arises with PEG ratio analysis is that it is based on projections of expected earnings and expected earnings growth.

Back to Google vs Amazon. Amazon trades at a forward (looking 12 months into the future) P/E of 33.53 while Google trades at a forward P/E of 17.60. Already it is apparent that investors are willing to pay more per dollar of Amazon's earnings than Google. But what is cheaper? When we look at the PEG ratios of both stocks it becomes more apparent. Amazon's PEG ratio is 1.56 while Google's PEG ratio is 0.92. Investors are once again paying up for Amazon shares while Google's P/E trades below its EPS growth rate. I tend to like companies with PEG ratios between 0.50 and 2. Even though neither stock trades above a 2 PEG ratio, Google is far more attractive on a long term basis. A lot of Amazon's growth is priced into the stock.

Fundamental analysis is a huge part of our investment selection process at PMC, and Price-to-Earnings, PEG and Price-to-Book ratios are all very important factors we take into consideration when making decisions.

Full Disclosure:

Our CEO, Asif A. Khan, CPA (or his family members) is long Google common stock.