The stock markets pour out a blizzard of prices, measures, ratios and percentages, and the statistics can overload a new investor with more numbers and information than he can handle. If you're diving into the market for the first time as an individual investor, one number you can concentrate on is the price-to-earnings or P/E ratio. In essence, the P/E reveals how the markets are valuing a company's stock and anticipating its future performance.
The P and E ratio measures the price of the stock divided by its trailing 12-month per-share net earnings. If a company has earned $1 a share over the last year, but its stock price has reached $10, then its P/E ratio is 10. The higher the P/E multiple, the richer the valuation assigned to the company by the market. The P/E ratio is a basic, standard metric for all stocks and shows up on the detail pages of online brokers as well as in some printed stock market tables, such as those appearing in Investors Business Daily.
Trends in P/E Ratios
Many stock-picking and investment sites offer charts to track P/E ratios over time. When a company's P/E ratio is rising, the market is growing more optimistic about that company's future prospects. Falling P/E, by contrast, shows a decline in the market's optimism.
It's also important, however, to examine a company's P/E ratio within the sector in which it operates. Companies in faster-growing sectors, such as telecommunications and software, tend to have higher P/Es. Stolid and steady businesses, such as utilities and energy, usually show lower multiples. The overall market also has a P/E ratio, which reached 20.5 among the Standard & Poor's 500 according to a screen in early 2015 on GuruFocus.
An investor can make good use of P/E multiples when considering his own individual investment style. If you're a growth investor who prefers companies that are trending hot among investors, search out the high P/E numbers. Value investors who are looking to get in comparatively cheaply, and buy anticipated future earnings at a lower price, should take a second look at low-P/E stocks. There's no right or wrong, good or bad P/E multiple, but there are cheap-vs-expensive stocks, in terms of P/E and market sentiment. It's also possible to use market P/E as a measure of the overall risk of stock investing. The average market P/E since 1935 stands at 15.86, meaning that a market trading for a higher multiple is more expensive, and thus more risky, than the historical norm.