High versus Low PE Ratio

Introduction

Let’s revisit the thought experiment where we are a local investor looking to buy a small business. In the downtown district there are two businesses for sale, each priced at $150,000. In order to decide between the two, we review the financial statements to determine which makes more money. Business A makes $15,000 or trades at a PE Ratio of 10. Business B makes $30,000 or trades at a PE Ratio of 5. Therefore, is Business B superior? Not necessarily. Business A is a hip and trendy coffee shop that has grown well, and some think it may become a town favorite. Business B is the local smoke shop, and is maintained poorly as its customer base shrinks each year. With these facts in mind, it should be easy to conclude that a low PE Ratio is not always superior. There are valid reasons for stocks to trade at a high or low PE Ratio. Although, if a valid reason is not apparent undervalued stocks and overvalued stocks can present themselves through PE Ratio.

Reasons for High P/E Ratio

A savvy investor should view a high PE Ratio as a premium paid for earnings. An investor is willing to pay a premium over today’s earnings if he or she believes earnings will increase rapidly in the future. Therefore, a key reason for justifying a high PE Ratio is rapid growth expectations. This can be seen in two stocks where positive future growth is undisputed, Amazon (ticker: AMZN) and Tesla (ticker: TSLA). At the end of 2020, Amazon traded at about 95 times earnings and grew at an impressive 35%. At the end of 2020, Tesla traded at about 1,500 times earnings and grew at an astounding 40%. Ultimately, if this growth continues the future PE Ratio will fall to more sensible levels. Therefore, if anticipated growth is not priced in via higher PE Ratios, a significant value opportunity would be present.

Reasons for Low P/E Ratio

A savvy investor should view a low PE Ratio as earnings for inexpensive prices. Financial markets are quite efficient, so inexpensive prices should not persist and there should be a valid reason for the low PE Ratio. Opposite to the above, a low PE Ratio can be caused by low growth expectations. Let’s observe two companies, General Mills (ticker: GIS) and Western Union (ticker: WU). General Mills focuses on packaged foods, a highly commoditized, competitive, and established market. They cannot grow market share by convincing people to eat for the first time, and there only choice is to take customers from competitors. Therefore, most of their growth is tied to inflation and population growth, both of which have remained low. At the end of 2020, General Mills trades at a low PE Ratio of 15 and grew around 5%. Western Union focuses on old school money movement and payment services. A once heavily relied on service is now provided in more efficient ways by many banks, credit card companies, or technology driven companies like PayPal (ticker: PYPL) or Square (ticker: SQ). Therefore, Western Union has experienced revenue decline since 2018. With this revenue decline, investors have punished the value of their earnings as the stock only trades at a PE Ratio of 13.

Negative P/E Ratio or N/A P/E Ratio

Sometimes a stock will trade at a negative or N/A or no PE Ratio. This occurs when a company has negative earnings or losses money. While the magnitude of a negative PE Ratio can tell you how much money a company lost, rarely do you see analysis based on this number.

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