Question

What may be a problem of comparing the P/E ratio of a stock to the P/E of the overall market?

Answer 1

P/E is given by dividing the price of a share/Earnings per share. It gives the number of times of the EPS that, the market is willing to pay for the stock. It reflects the risk of the share also as the P/E multiple changes with significant changes in risk.

Thus, the P/E of a stock reflects its earnings and total risk, the total risk comprising of systematic risk [market risk] and non-systematic risk [firm specific risk].

In contrast, the P/E of the market reflects the earnings of the innumerable assets in the market and their risk. But, the market as whole will not have any non-systematic risk as, it is a very well diversified portfolio. It then will reflect only the systematic risk. Hence, comparing the P/E of a stock with the P/E of the market will not help in assessing the earnings/risk profit of the stock. For a proper comparison, the P/E of a stock should be compared with industry P/E or some benchmark firm in the same industry..