What is a good P/E ratio?

The P/E ratio looks at the price of a stock in comparison to its earnings per share over a period of time. What investors consider a great P/E ratio varies from industry to industry. A cheetah can't be compared to a house cat. Nor can a retail company be compared to a tech industry giant.  

In April 2021, companies in the retail industry had an average P/E of 17. In comparison, the P/E of tech companies - which is typically much higher -  averaged 193.65 in the same period.

This is because different industries are evolving and making money in different ways, which results in varying growth prospects and profit margins. Manufacturers rely on expensive machinery that boosts their capital costs; retailers simply buy products and re-sell them at thin but stable margins; IT or biotech firms rely mostly on brain power to reap profits on fast-growing but risky markets; while banks' earnings depend largely on loan rates defined by the general interest-rate environment.

P/E ratios, both trailing and forward, are important factors to consider in your investment decisions. It’s a good idea to do some research, as one-off events can impact P/E ratios.

A low P/E could be the result of temporarily higher earnings driven by one-off factors (e.g. recent sales of assets) or unsustainable earnings path (e.g. number of face masks sold during the height of the pandemic).

Even worse, the company might face a secular decline. Think of DVD rental stores that might have appeared cheap based on past earnings some time ago but those earnings went to zero in a very short time.

Having said that, a high P/E is not necessarily desirable. For example, Tesla and Coinbase shares are highly valued due to their projected growth and not because of their earnings. Should this projected growth fail to materialize, investors could face heavy losses.

The lower a company's P/E in comparison with the industry average, the higher the potential upside for the stock.

Beware of the limitations of using this tool when investing, especially when it comes to value traps. These are companies that seem to be very cheap based on P/E metrics but risk factors undermine their future profitability. For example, a country’s coal industry may be doing well now. However, the world is set to move away from coal, which will inevitably lead to a sizable downturn.

The key takeaway when looking for a good P/E ratio is to always remember the fundamentals. Look for the industry average, check the data, and watch out for value traps.