March 23, 2021Mac McLaughlin

Investing Terms Explained: The Price to Earnings Ratio/Multiple (P/E)

Guacamole is how much?? Is that expensive?

Key Insights:

The Price to Earnings (P/E) Ratio/Multiple gives the investor a better indication of how expensive/cheap a stock really is, when compared to alternatives.
To most effectively use the P/E ratio in investing decisions, an investor should compare the current P/E of a stock to other “similar” companies, as well as it’s own historical data.
A higher P/E = the stock is more expensive, while a lower P/E = a cheaper stock. “What is the right level” is the question that portfolio managers try to answer when making investment decisions.

Chipotle Guacamole or Qdoba?

Guacamole is delicious – and to answer the question no one is asking: yes, I do in fact pay “extra” – wherever I go.
How much “extra” am I willing to pay? Should I pay that much? Should I go somewhere else?

Let’s say you’re a guac lover like me and you just have to have it. You pay $1.95 at Chipotle, and in return you get the satisfaction of enjoying a generous helping of creamy, fresh spread full of tomato, herbs and other accoutrement. Is that expensive? How would you measure that? If you found out Qdoba lowered their price to a dollar – keeping the quality of the product constant – would you go there instead for your avocado fix? Maybe you would, if you wanted to find the best option for the lowest price.
In investing, “is this stock expensive or cheap?” is slightly more complicated than how much one share of that company costs. Most stocks range from a few dollars per share, to in some cases thousands of dollars per share. Like the guac however, you are willing to pay the price in dollar terms, and so your goal is to determine whether that that stock is “cheap or expensive” relative to alternatives that you deem to be the same. After all, we are all trying to “buy low”.
Unlike guac which we purchase to enjoy on our meals, we buy stocks for two main reasons; (1) we think that the stock price is going to go higher, and thus we can sell it when that occurs to lock in capital gains and (2) the stock is going to pay us money while we hold it (in the form of dividends), and regardless of price movements in the short/intermediate term we are getting paid on our investment.
As simple as this sounds – it is important to remember that when you buy a stock, you are very technically an owner of a company. Amazing to think about isn’t it? As a proud owner of a company (albeit potentially a very, very small owner) you want the company you own to make money. That is, after your company generates revenue and pays all of its expenses, it has money left over either to put back into the company to help it continue to grow, or pay out some of its money to its owners in the form of a dividend. The money “left over” is called the company’s earnings.
Let’s say that the company that you own has earnings – money left over. The next question to ask is how many shares – or units of ownership – are available to own for that company? If you take all of the earnings that the company has and divide it by the number of shares that the company has available in the market, you will arrive at your earnings per share (EPS) – or in other words, how much each owner is entitled to, based on how much of the company they own. In equation form, that looks like this:

Total Company Earnings / # of Shares available in the market = Earnings Per Share

So, we have established that if you are an owner of a company, and that company makes money (after paying all expenses), you are entitled to those earnings. How much are you willing to pay for those earnings?
Much like looking up the price of guacamole which is easily accessible online, so too are stock prices of publicly traded companies. $X will buy you one share of a company, which if that company makes money you are entitled to a portion of as an owner of that company. Therefore, as an investor, when you buy a stock you agree to pay a certain dollar amount not only because you think the price is going to go up, but also to share in its earnings.
The price you pay per one share of stock, divided by the earnings per share of that stock, equals the Price to Earnings Ratio/Multiple. Why is it sometimes called a “multiple”? Because if you look at the equation it answers the question “how many dollars am I willing to pay for every one dollar of earnings that this particular company generates?”.
Example: Company XYZ is trading for $45 per share. There are 1,000 shares of XYZ available to own, and XYZ has $10,000 in earnings.

$ 10,000 earnings / 1,000 shares = $10 of Earnings Per Share (EPS)
If you own one share, you are entitled to $10 worth of XYZ earnings.

XZY is trading for $45 / $10 earnings per share = 4.5 (P/E or “Multiple”)
On a relative basis, you agree to pay $4.50 for every dollar of earnings that each XYZ shareholder is entitled to.

Now - Chipotle or Qdoba? If the quality of their guac is the same (both companies offer me the “same earnings”), the answer is simple: whichever costs less relative to the other. All things being equal, if two companies are similar enough for you to consider them equivalent to one another (two large cap companies that sell online advertising, and you want to own shares in a company that sells online advertising), you will choose to purchase the one that costs you less to buy $1 worth of that company’s earnings.
When portfolio managers make decisions on which stocks, ETFs or Mutual Funds to own, a large part of their consideration is the P/E multiple – how much am I willing to pay for $1 of that asset’s earnings? The lower the multiple, or P/E ratio, the “cheaper” the buy – either relative to its peers, or relative to that same asset’s own historical multiple.
For example if you love company ABC – and last week ABC had a P/E multiple of 16x (you pay $16 for every $1 of earnings per share that ABC generates) – and this week ABC has a P/E multiple of 14x, you may recognize that it is “cheap” relative to where it has been before, and decide to buy: regardless of what the dollar amount is per share.
Chipotle? Qdoba? Homemade guac, or even – dare I say it – pass on guac altogether, because on a relative basis it is “too expensive” for what you get in return, you will be prepared to make these decisions as a guacamole enthusiast, or an investor in the financial markets.