The share price of a company is a reflection of its ability to generate earnings in the future. As the earnings of a company grow, so should its share price. Price-earning ratio (PE) is an important factor that investors look at while selecting an investment grade company. PE is a simple ratio of a company share price to its earning per share. It is usually based on “trailing earnings”, i.e. earnings from the past four quarters, although year-ahead projections “forward earnings” are sometimes used.

When investors like a company right or wrong, they drive its share price upward — and in the process it’s PE ratio, to a level where it becomes overpriced. By comparing it to the PE ratio of companies in the same industry, the PE provides a metric to judge how reasonable the share price of a company is. Companies with lofty PE must grow their earnings consistently to meet the investors’ high expectations. Sooner or later such companies miss their earning targets and consequently their share prices tumble.

High PE ratios are usually associated with growth stocks, and frequently flag the question — is it worth the risk to participate in a bright future, or maybe the share price is overvalued. Low PE ratios relate to value stocks, which are usually good for steady dividend income.

Companies’ PE ratio are one piece of the puzzle, and have to be taken with other factors, such as price-to-book ratio, sales projection, long term interest rate and inflation. Meaningful comparisons are those made with the company earlier performance and also with other companies in the same industry.

In 1982, the PE ratio of the US S&P 500 index was just 7, i.e. investors were willing to pay only $7 for every $1 corporations earned on their behalf. By mid 1999, people were willing to pay $34 for every $1 of earnings generated by these same companies. The main causes for such disparity were, lower interest rates, improved profitability, and earnings reinvested at high returns. However the majority of the climb in stock prices can be attributed to emotion, the sheer willingness of investors to pay higher and higher prices without regard to value. For many investors with a value orientation it became difficult to justify buying anything with such PE multiples.

PE ratios may move individually based on one company performance or collectively based on the market. A substantial amount of funds is usually parked in bonds. Lower interest rates mean lower bond returns. So it follows that lower rates make stocks much more attractive. As money leaves the bond market and heads for the equity markets, the average stock price rises and PE ratios go up. Markets of course have their own cycles, and when the average PE gets exceptionally high, it often gets in a crash. Having a high price-to-earnings ratio increases the pressure on management to perform, as well as increasing the risk on investors if the company falls short of expectations. There is a limit to any company performance, and when the expectation i.e. PE is driven to a level higher than this limit, disaster has to happen.

Percentage profitability and earnings vary from one sector to another. Accordingly a high PE ratio in one industry might be acceptable in a different one. Utilities, energy and old economy industries tend to have low PE ratios due to limited growth expectations. Technology companies on the other hand, reflect high expectations due to innovation and improved productivity. Hence meaningful comparisons are those made among companies in the same sector.

Between 1995 and 2002, price earnings ratios have fluctuated between 22 and 47 for technology companies and between 13 and 23 for non-tech companies. In the late nineties PE ratio for technology companies increased dramatically due to the soaring expectations of high tech and in particular Internet companies. These elevated PE ratios could not be sustained due to the poor performance of most of the Internet start-up companies.

A high PE ratio of a given company points to superior performance expectations from its operation. Although this is initially a positive sign, however it has to be regularly supported by actual results. The ratio might increase to a dangerous level at which it becomes difficult for the “successful” company to meet the high expectations. In fact whenever a company with a high PE misses a profit target, its’ share price plunges.

(Salim J. Ghalayini is a professional engineer and a seasoned investor. He manages several investment accounts.)