PETER LYNCH 00:00
The price earnings ratio (P/E) is something that some people make very complex. It is actually very simple. If a company is selling for $100 a share and they are earning $10, it has a price earnings multiple of 10.
The P/E ratio can be thought of as the number of years it will take the company earn back the amount of your initial investment, assuming of course that the company’s earnings stay constant.
Why look at P/E? It can tell you if you are paying too much for a stock. The higher the P/E, more expensive the stock relative the company’s future earning power. The lower P/E, the cheaper the stock. I use a rule of thumb to level out these differences.
A fairly priced stock has a P/E that is about equal to the expected annual growth rate over the next three to five years. If the P/E is substantially higher than the growth rate, the stock is normally expensive. If the P/E is substantially lower, stock is probably cheap.
A stock’s P/E, in part, depends on the industry it is in. When you look at a growth company, compare the company’s growth rate and its own P/E to that of the industry. All other things being equal, if you find a company with a much lower P/E and a higher growth rate you are off to a good start.
You can also compare a company’s P/E to its own historical P/E. If the company normally sells for 25 times earnings, and now it is selling at 15 or less, you have to ask yourself why. The company could be maturing. Competition may be entering the field and its growth prospects may be uncertain. But maybe it’s simply been beaten down by some other factors and it is possibly a bargain. It is worth researching.
Back in the 1970s, Electronic Data Systems or EDS had a P/E of 500 times earnings. If you would have invested in a company with a P/E this high when Columbus discovered America and the company’s earnings stayed constant, you would just be breaking even today.
In 1974, EDS performed very well, but the stock fell from 40 to 3, simply because the stock was so grossly overpriced relative to current earnings.