About Price to Earnings (P/E) Ratio

The Price to Earnings (P/E) Ratio is the most commonly used valuation metric used by investors

Posted in FAQ | Traders' Delusions, Submitted by Trading Critic on Wed, 2006-11-22 02:40.
The Price to Earnings (P/E) Ratio is the most commonly used valuation metric used by investors

The Price to Earnings (P/E) Ratio is the most commonly used valuation metric used by investors to help determine is individual stocks are reasonably priced. It is a simple ratio to calculate but can be confusing to interpret. The ratio can be useful in some cases yet useless in others. The ratio was popularized by Benjamin Graham - author of "The Intelligent Investor" (a must read for all serious investors). Graham used this financial ratio as a quick way to determine if the company stock was trading on an investment or speculative basis.

How is the Price to Earnings (P/E) Ratio Calculated?

The Price to Earnings (P/E) Ratio is rather simple to calculate. You simply take the net earnings and divide by its average outstanding shares and then divide it with its Earnings Per Share or EPS.

P/E Ratio = [ Net Income - Dividends on Preferred Stock ] / [ Average Outstanding Shares on Issue ]

So if the stock is at $50 and the company pays out a dividend of 10 percent or $5 a year then the P/E ratio is 10. Most brokers would have some facility to automatically display the Price to Earnings (P/E) Ratio for a stock. If you are hard pressed to find it you can even look up a company's P/E ratio on Yahoo! Finance. There are two ways to calculate EPS which result in either a trailing P/E or a leading P/E (projected P/E). A trailing P/E takes historic data using the EPS from the last four quarters. A leading P/E takes estimated EPS figures expected over the next four quarters (which is just the analyst's best guess).

Now that I've calculated the P/E Ratio, What does it Mean?

Most investors would nominate the P/E ratio to be "the" financial ratio to use to determine if a stock was cheap (if the company had recently fallen out of favour) or overpriced (could be the stock was the latest "hot-pick"). To give the number some meaning, or a little bit of context you'll have to research the typical Price to Earnings Ratios of other companies of the same type and industry - you could calculate comparable company P/E's as an average. This will determine what P/E ratios are "normal" for that type of company in that certain industry and this benchmark number can give context to the P/E ratio you calculated and hence allow you to compare the two numbers. Usually similar types of companies or companies in the same industry are classified in industry sectors like infrastructure, retail, biotech, pharmaceuticals, telecommunications and utilities.

By comparing the Price to Earnings (P/E) ratio from the company you're examining with the P/E average for the industry sector you can determine if the company is cheap or expensive relative to its peers. If the company P/E is lower than the average then its considered cheap if the company P/E is higher than the average P/E then it is relatively expensive than its peers. However, you the investor should then question why is the P/E ratio lower than its peer companies.

Another interesting use for this financial ratio is to think of it as the number of years for the company's earnings to pay you back for your initial investment (Although this number may increase or decrease based on the company's future performance). Yet another way to think about the P/E ratio is how much you are paying for $1 of the company's earnings.

Yet another way to view the P/E ratio is to consider this: The EPS figure is usually based on historic figures. The current stock price usually reflect what the market participants think the company will be worth taking into consideration what is known about the current status and the future plans of the company.

It is important to know when the usage of the Price to Earnings Ratio is valid as in some situations it can be meaningless. The ratio is only useful for evaluating a stock when you compare it with other "comparable companies" in the same industry with similar size, financial, management depth and future growth.

The Price to Earnings Ratio can be at times inaccurate and simply not useful. As you can understand by now, the P/E ratio can have a few interpretations and those interpretations are subjective which could lead to mistakes in investment judgment. P/E figures can be distorted due to economic cycles related to the company or the market: with factors like inflation as well as companies going expansionary or contractionary phases as well as the whole market sentiment (bullish or bearish).

Conclusion

Calculating the P/E is easy but understanding it and using it effectively could take a bit of leg work. Just because a company's P/E is cheap doesn't mean it's a buy and just because the P/E is high doesn't mean the company is a sell. An undervalued stock with a low P/E does not guarantee that it will recover and a stock with a high P/E does not give any strong indications that the stock price will soon come tumbling down in a correction. It is wise to look at the context of the P/E ratio compared to the company's industry peers as well as the company situation, so don't base any investment decision solely on this financial ratio.

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