What other metrics should I consider?
A Price-to-earnings ratio is a standard measure of valuation used by most investors and for this reason shouldn't be ignored. Personally, however, I usually prefer to look at the enterprise value-to-EBITDA ratio for two reasons. First, "enterprise value" factors in net cash or debt on the balance sheet. Second, "EBITDA" adds back non-cash charges like depreciation and amortization to the earnings side of the equation getting closer to a "cash earnings" number. Though it's not always 100% accurate, Yahoo Finance calculates this figure for thousands of companies under the "Key Statistics" tab on their quote page.
I take it under consideration, however there are a lot of other things that matter just as much or more like price to book in my opinion. Also you have to be careful that the P/E ratio is not the trailing P/E. Past performance does not guarantee future results.
Price to Earnings (PE) is just one of many different tools you can use to understand how expensive or inexpensive an investment is. One nice element about relative valuation tools, like PE, price to sales, or price to book value, is that they facilitate a comparison. They can help you understand how expensive or inexpensive the investment is relative to a competitor, relative to their industry, or even relative to their own history. In some cases, these may be very relevant tools to use, but in others, they may be meaningless.
Other tools are also commonly used by investors which are more absolute in nature, in that they help you calculate a theoretical price for the investment. These tools include a variety of discounted cash flow models.
All valuation models have their advantages and disadvantages though, so there isn’t a magic bullet formula which necessarily works best, or which works all the time. Where valuing an investment is concerned, about the best you can say about any single tool is that it helps you gain perspective, and in that sense, it’s often best to use several tools to help give you a solid understanding about the investment and its price.
In addition, I have found from experience that while there are dozens of ways one can successfully manage money, the most successful investors are those who find a strategy which fits well with their personality, and which they can implement consistently over time. This doesn’t mean that you can’t continually refine your process; in fact, it’s wise to do so. But if you approach your investment process similarly each time using the same tools and approach, you will be more consistent in your decisions, which will benefit you over time.
Price-earnings ratios are an important part of our "rule-of-thumb" valuation assessment. Equally, we look at the price-to-free-cash-flow ratio because dividends, share buybacks, debt reduction and investment are made from cash flow.
How do we employ p/e ratios?
First, we define p/e ratio as price divided by the average earnings-per-share for the past 3 years. Most financial publications use trailing 12-month earnings, and many investment firms use estimated future earnings.
To give us a relative sense of valuation, we then compare this ratio to the company's 10-year average p/e ratio, the p/e ratio of competitors, and the ratio of the overall market.
We also inverse the p/e ratio to get the "earnings yield." A stock trading at 10 times earnings has an earnings yield of 10%, for instance.
This can help with looking at the big picture. Ten years ago or so, many of the great American blue chips were selling at p/e ratios of 30X or more. That's an earnings yield of 3.3% or less.
Now those same companies are selling at p/e ratios of 12X or less. That's an earnings yield of 8.3% or more.
If the p/e ratio is low on all accounts, and we also like the company after considering other quantitative measures around profitability, financial strength, and valuation, we will then make qualitative assessments around the durability of the business before we buy.
Historical research has shown that the most predictive measure of value for a stock is the P/E ratio. In other words, low P/E stocks tend to outperform high P/E stocks over most major market cycles. That being the case, the P/E ratio is definitely worth considering.
Another metric we use is the PEG ratio, which is the PE ratio divided by the projected growth rate. We typically like to see our PEG ratios less than 2 for companies we are considering.