Monday, January 16, 2006

More about what a P/E ratio is

A quick primer on P/E ratios

The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider.

You calculate the P/E by taking the share price and dividing it by the company's EPS (Earnings Per Share)

P/E = Stock Price / EPS

For example, a company with a share price of $400 and an EPS of 10 would have a P/E of 40 ($400 / 10 = 5).

What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.

Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these “diamonds in the rough” before the rest of the market discovered their true worth.

Most stock-quote systems such as Yahoo! Finance will automatically figure the price earnings ratio if you ask for a detailed quote on any company. I personally found the best ones to be Google Stock Quotes, just type in the ticket and the search results will do the rest.

Once you have the magic number, it's time you begin to wield its power. It can help you differentiate between a less-than-perfect stock that is selling at a high price because it is the latest hot-pick on Wall Street, and a great company which may have fallen out of favor and is selling for a fraction of what it is truly worth.

In addition to helping you determine which industries and sectors are over / under priced you can use the p/e ratio to compare the prices of companies in the same sector against each other. For example, if company ABC and XYZ are both selling for $50 a share, one is not more expensive than the other. Wrong!

Company ABC may have reported earnings of $10 per share, while company XYZ has reported earnings of $20 per share. Each is selling on the stock market for $50. What does this mean? Company ABC has a price to earnings ratio of 5, while Company XYZ has a p/e ratio of 2 1/2. This means that company XYZ is much cheaper on a relative basis. For every share purchased, the investor is getting $20 of earnings as opposed to $10 in earnings from ABC. All else being equal, an intelligent investor should opt to purchase shares of XYZ; for the exact same price ($50), he is getting twice the earning power.

Here is a sample chart (of Google : GOOG) that could to help you drill down these concepts.

1 comment:

Calico Cat said...

Every investor knows about the P/E ratio. That's why there's more money in value investing based on reading the balance sheet.