Expert: Paul Henneman - 10/16/2006

Question
Hi Paul,
I am a bit confused by what is a good Price / Earning ratio score.

I understand that the ratio reflects the price of the share divided by earnings.

So at the moment, Barclays has a P/E ratio of about 10. I thought this was a good score as it indicates that in about 10 years the shares would earn back the value of the cost. To my mind this seems good.

However, information I've read suggests the opposite. If the P/E of a stock is high, then it reflects investors are prepared to accept that currently earnings would take many years to recoup the price you pay. This suggests they know the company is about to do well and prepared to take more of a gamble. I can see some logic here but see this more of a sign that people are paying too much for something that doesnt warrant the cost.

So have you got a rule of thumb? Is Barclays P/E of 10 good or bad?

regards,
nick

Answer
Thank you Nick for your question!
   Yes, I do completely agree with you. A lower P/E ratio is better. This is commonly one of the central data points that professionals use to seek out undervalued companies.
   There is a certain segment of investors that do look for high p/e ratios as more acceptable, for the very reasons that you list. However, these companies, on a simplistic level, could be considered 'overvalued', and further stock price increase would depend upon the stocks momementum and maintaining very large earnings growth. It is also true that small cap companies fit more into this profile than large ones.
   What is the solution? I strongly recommend that you use P/E ratio in a compartive way. For example, you mention a p/e ratio of 10 for Barclays. 10 may or many not be good, what is most important is that you compare that p/e ratio with Barclay's major competitors and the average p/e ratio for that industry overall. The average p/e ratio often changes fairly dramatically over time, and 10 could be average, or very good depending on the current status of the stock market.
  In summary, most would agree with your analysis. Only risky, more frequent traders that seek very high returns in small cap companies would disagree. And these types of investors can make a so called killing on a stock once in a while, but more often than not they lose money when the price turns down. To seek a high p/e ratio is risky business. Look instead for a low p/e ratio when compared to the stocks competitors, industry, and overall sector groups.

I hope this helps! Please do not hestiate to follow up with me if I can be of any additional service,

Sincerely,
Paul Henneman
President
ValuEngine Inc
www.ValuEngine.com