May 2, 2011 | In: Opinion
Is the P/E Ratio Relevant?
One of the factors that I use to buy stocks is their P/E Ratio (Price/Earnings Ratio). The P/E Ratio is calculated by dividing the share price by the EPS (Earnings Per Share). For example, in the case of RIG, the P/E Ratio = Share Price/EPS = 73.10/2.97 = 24.61. This tells us that it will take Transocean LTD 24.61 years (at the current EPS) to buy back its public debt. So, the lower the P/E ratio is, the better.
But what is the maximum acceptable P/E ratio to consider a stock?
In my opinion, a stock that is trading about a P/E of 30 should be avoided as it is considered to be overvalued. Here’s a breakdown of the P/E Ratio, as well as the stock attractiveness:
P/E is between 0 and 5: Technically, the stock is very attractive when it has this P/E. But one has to think why is it trading that low, when it’s that attractive. Obviously there’s more to the story, so it’s better to research the stock, maybe the company (or one of its products) is under investigation/probe, is constantly changing its forecasts, or their main product is soon to become obsolete. The public company with the lowest P/E is Newcastle Investment Corp.. This company is able to buy back all its shares in almost 6 months!
P/E is between 5 and 10: A very attractive stock, but also needs to be researched as there’s also probably more to the story.
P/E is between 10 and 20: This is where most of the delicious and blue chip stocks are located, including AAPL, GOOG, C, and the rest. I find that stocks located in this range are the least risky, and can provide the investor with decent profits.
P/E is between 20 and 30: The stock is now less attractive, but should still be considered if it’s a solid company
P/E higher than 30: I avoid all stocks with a P/E higher than 30, although many investors don’t (again, look at NFLX). In my opinion these are risky stocks, and any negative change in the market climate for the relevant industry of the company can have catastrophic events.
Now my question was, Is the P/E Ratio Relevant? Personally for me, it is, but, apparently for many other investors, it’s meaningless. Most investors, while buying or selling shares of a company, try to see into the future of the company, what are its forecasts? Will there be any change in management? Will the products offered by the company face competition? Will the products become obsolete in the near (or the medium) future?
There are many examples of very decent stocks demonstrating that investors care more about the future of the company rather than it’s current P/E. Examples of these stocks include:
AIG: The insurance giant has a P/E of 2.19, but investors have been burned so many times with this stock (AIG used to trade above the $1400 4 years ago). Investors also have questions about the future of AIG, and whether or not they still have some hidden (dark) secrets.
RIMM: The Canadian blackberry creator is trading at a P/E of 7.6, but Research In Motion is consistently releasing estimates that are lower than the analysts forecasts. Not to mention, of course, that investors are skeptical of its products. I’ve said it before, RIM is no longer innovative, and, so when it regains the innovation momentum, and it demonstrates some humility, then expect the stock to drop considerably more.
Obviously, the P/E ratio is of very little relevancy when buying or selling stocks. Investors care most about the future of the company (on the long term), and about rumors surrounding the company (on the short term).