Price/earnings ratio

Some investors use the P/E (Price/Earnings Ratio) to check whether a share is overvalued or not. Although many people think that companies with a high P/E ratio (20+) are not worth investing in, this is certainly not true. It is widely accepted that a low P/E is below 10-12.

A rising P/E ratio reflects investors’ expectations about the future of a company. If the P/E is high, market participants believe that the company will live up to expectations, which is why it is worth paying a significant premium for the earnings per share (EPS) it generates. If the P/E is low, no one expects a good future.

Some brief examples:

Does a low P/E mean a good investment? Let’s look at Bed Bath and Beyond (BBBY). BBBY’s P/E ratio has been below 10 from 2016 to 2019. Does it look like an attractive investment? Here’s a historical graph of BBBY’s P/E ratio:

Source: WolframAlpha

Now let’s look at the price trend since 2016, when BBBY’s P/E ratio became very attractive and below 10.

Source: Portfoliovisualizer

We can clearly see that BBBY lost about 80% of its initial investment when the S&P500 more than doubled. Since BBBY has become a loss-making company, we no longer have P/E data.

Or maybe BBBY’s P/E ratio only became so low after this fall and now there is an investment opportunity? OK, let’s take that into account too.

Source: WolframAlpha

Is it a rule that a low P/E means a bad investment? NO. But it is worth thinking carefully about whether this low P/E ratio masks pessimism in the market about the future of this company. There are some companies that have a low P/E, whose share price has a lower growth rate than the indices, but which pay higher than average dividends. Good examples would be Ford Inc, AT&T Inc, Verizon etc.

On the other hand, let’s look at a high P/E ratio and how it can hide a company whose share has huge upside potential.

A very good example is Adobe Inc. (ADBE) company. A company that was growing rapidly and, during the correction of 2022, lost a lot of value. Let’s take the same comparative period as with BBBY, and see what the results would have been if we had invested in ADBE with a high P/E and held on to it until mid-2022.

Source: WolframAlpha

Source: Portfoliovisualizer

Your eyes do not deceive you. In 2016, this company’s P/E was just above 70. While the P/E has been gradually declining, the company’s share value has been growing at an incredible rate. Why? Because investor expectations were high for Adobe Inc. and market participants were willing to pay a fat premium for the opportunity to buy shares in this company. And their expectations were met – the company grew fast and increased its profitability.

Again, it is not a rule that a high P/E ratio always signals an opportunity to get rich. The main point of this article is that a low P/E and a good investment is a myth, just as a high P/E is a bad investment. The P/E reflects the expectations of the market, and whether or not these expectations are justified is a matter of a more detailed analysis.