The Price to Earnings (PE) ratio is also known as the earnings multiple and is calculated by taking the price of the stock and dividing by earnings per share (EPS). Intuitively, capping the Price to Earnings ratio at 20 seems arbitrary. Why 20? Most people would say it’s better to compare PE against other companies in the same sector or historical trends. While those comparisons do hold merit, there are a few reasons why we want to cap PE at 20 for dividend investing.
Usually, securities with high PE ratios are growth stocks that have a competitive advantage and hope to rapidly grow earnings and market share. Thus, their future earnings potential is priced into the current valuation of the stock and causes PE to increase. But, why pay a high valuation above 20 times earnings for mature dividend companies that have been around for decades, have strong market shares and, conversely, slower growth potential? It doesn’t make sense.
So why 20 in particular? Well, a PE ratio of 20 equates to a 5% earnings yield. So, it’s not the end all be all, but it does provide us with a baseline from which to use valuation as a screening tool. Investing is highly situational. Don’t let a PE of 20 stop you from investing in a particular stock if the right opportunity presents itself. When comparing companies, you want to evaluate earnings stability, growth prospects, sector portfolio weight and valuation. PE ratios are just one tool in the tool belt.