The price-to-earnings ratio is an important metric and one that is often quoted in financial circles. It is computed by dividing the price of a stock by its share earnings. What it shows is how much the market values a dollar of a particular company’s earnings. In this way, it is a valuation tool—unlike a current ratio, for example, which is useful in highlighting a company’s financial strength.

Price to earnings, often shortened to just P/E, isn’t as simple as it may seem, though. This is because there are different ways of calculating P/E. You can use the previous 12 months of earnings to create a “trailing” P/E or you can use the estimated earnings over the next 12 months to get a “projected” P/E. Both will be called P/E and may or may not be differentiated by the person using them. Value Line, meanwhile, provides both a trailing P/E (labeled as such) and a blended P/E that typically combines two quarters of trailing earnings with projected earnings.

There are many rules of thumb on Wall Street and P/E is no stranger to such rules. For example, a P/E around 20 is often viewed as expensive or an attribute of a growth stock. A P/E in the single digits is often seen as a sign of an undervalued company. Anything in-between, well, it depends. Rules of thumb can only get one so far, particularly with a valuation oriented metric.

For example, current ratio gives an idea of a company’s ability to pay its near-term bills. If a company has a high current ratio, it can probably cover its near-term obligations without a problem. With P/E, however, saying a company has a P/E of 19 doesn’t provide that kind of certainty. Using a concrete example, Coca-Cola (KO - Free Coca-Cola Stock Report) had an average annual P/E of 18.5 in calendar year 2006. Was the stock expensive at the time? Would it help to know that the company recently had a P/E of 19.0?

The answer is that you can’t really tell. In 2006, Coca-Cola’s Relative P/E (its P/E in comparison to that of the broader market) was 1.0, meaning it was trading in line with market valuations at the time. So, at the time, the stock wouldn’t have appeared to be expensive. However, the recent P/E of 19, only slightly higher than it was in 2006, is 1.3 times that of the market—this suggests that the stock is trading at a 30% premium to the broader market.

The change relative to the market isn’t because the recent P/E is 50 basis points higher, it’s because the market’s valuation has changed. This is a great example of how P/E is relative, not absolute. This is why using the rule of thumb that a P/E near 20 is expensive, may not work out as cleanly as advertised. That said, a P/E that is well into the double digits (say 37.6) should, in fact, be a warning sign that something is going on. Either the market is expecting massive earnings growth or earnings have, for some reason, fallen, and the market expects the drop to be temporary. Either way, caution would be in order.

Some industries also defy the traditional P/E logic. Cyclical stocks are the best example. Very often investors will bid the price of such companies higher in anticipation of improved performance—leading to high P/E ratios. If earnings catch up, the P/E will start to fall. When the P/E is low on historically high earnings, investors are discounting the earnings because they are expecting the cycle to change course and earnings to ultimately decline in the near future. So, once again, context is important—only this time that context is the type of industry in which a company operates.

A company’s own history is another context in which to view P/E. For example, Verizon (VZFree Verizon Stock Report) recently had a P/E of 17.2. That’s a level not consistently seen since the recession of 2001, which was led by the technology bubble bursting. Since that time, the P/E has more frequently been in the 13 to 14, range as the company has transitioned to more of a cell phone service provider than a land line provider. With a P/E harkening back to the days leading up to the tech bust, it would be reasonable to have some concern about Verizon’s recent valuation levels. This is true despite the recent dividend yield of 4.7%, which is well above the dividend yield of the broader market.

In addition to the recent P/E, Trailing P/E and Relative P/E, Value Line also shows a figure called the Median P/E. This figure provides the historical context noted above, by presenting the average annual P/E ratio of a stock over the past 10 years, with certain statistical adjustments made for unusually low or high ratios. Thus, in one quick number, you can see how the current P/E compares to the company’s recent history.

What’s important to remember is that P/E is a figure that, in and of itself, doesn’t provide context. While you can use so called “rules of thumb,” you would be better served taking a deeper dive into P/E to use it as a comparative figure; to a company’s own history, the levels of the broader market, and to compare similar companies.
