Are you in the camp that believes a stock with a low price-to-earnings ratio is a bargain and a stock with a high P/E is considered expensive? Here is another way to look at it when searching for stocks.
The P/E ratio usually is calculated by dividing a stock's current price by the trailing 12 months of earnings per share.
A common belief is that stocks with low P/E ratios are undervalued and should be bought, and high-P/E stocks are overvalued and to be avoided.
History shows higher P/E ratios are commonly seen in bull markets, whereas lower ratios are found in bear markets. One exception is cyclical stocks: They can have lower P/Es even in bull markets.
You Get What You Pay For
Quality merchandise comes with a higher price tag, and the same can be said for stocks.
A stock's price reflects investors' perceived value for the stock, which goes back to supply and demand. If investors feel a stock has strong earnings growth potential, they will drive the stock price higher.
A higher price results in a higher P/E, because price is the numerator in the ratio. Companies with stagnant earnings growth and no catalyst to push the stock higher are not a bargain if their price doesn't rise.
Big Growth Stocks Have Big P/E Ratios
In his book "How to Make Money in Stocks," IBD founder William O'Neil said P/E ratios won't tell you if a stock price will rise or fall, and the ratio should not be a factor in buying stocks. A better measure is accelerating or sharply increasing earnings-per-share growth.
By looking at historical winners through the decades, if you screened out stocks with P/Es greater than the market averages, you would have missed out on many big opportunities. O'Neil's studies found that from 1953 through 1985, the best-performing stocks showed an average P/E of 20 as they started to make gains. The Dow Jones Industrial Average had an average P/E of 15 at the same time.
As these stocks started to climb, their P/E ratios increased to around 45.
It was even more pronounced from 1990 to 1995, when top growth stocks had an average P/E of 36 and up into the 80s. The best performers started with ratios in the 25-50 range, and grew to a lofty 60-115 level. As you can imagine, it was even more dramatic in the late 1990s as valuations soared.
If you overlooked Microsoft in 2021 due to higher-than-average P/E ratios, you would have missed two opportunities. First, shares broke out of a cup base the week of June 25 when its P/E ratio was 37. The stock gained 16% until it peaked in August and started a new base.
If you missed that buy point, there was another breakout the week of Oct. 22, when Microsoft's P/E was 39. The stock climbed an additional 14% to its all-time high in November.
This article was originally published in November 2022 and has been updated.
