After finding the price of a particular stock, usually the next number everyone looks at is the P/E ratio.
Price/Earnings (P/E) is the ratio of a company’s share price to its per-share earnings.
A P/E ratio of 10 means that the company has 1 of annual, per-share earnings for every 10 in share price (earnings by definition are after all taxes and etc.).
A company’s P/E ratio is computed by dividing the current market price of one share of a company’s stock by that company’s per-share earnings.
A company’s per-share earnings are simply the company’s after-tax profit divided by number of outstanding shares.
A company that earned 5M last year, with a million shares outstanding, had earnings per share of 5.
If that company’s stock currently sells for 50/share, it has a P/E of 10.
At this price, investors are willing to pay 10 for every 1 of last year’s earnings.
P/E is traditionally computed with trailing earnings (earnings from the past 12 months), which is called trailing P/E.
Sometimesit is computed with leading earnings (earnings projected for the upcoming 12-month period), which is called a leading P/E.
For the most part, a high P/E means high projected earnings in the future.
But actually the P/E ratio doesn’t tell a whole lot, but it’s useful to compare the P/E ratios of other companies in the same industry, or to the market in general, or against the company’s own historical P/E ratios.
Some analysts will exclude one-time gains or losses from a quarterly earnings report when computing this figure, others will include it.
Adding to the confusion is the possibility of a late earnings report from a company; computation of a trailing P/E based on incomplete data is rather tricky (it’s misleading, but that doesn’t stop the brokerage houses from reporting something).
Even worse, some methods use so-called negative earnings (i.e., losses) to compute a negative P/E, while other methods define the P/E of a loss-making company to be zero.
Worst of all, it’s usually next to impossible to discover the method used to generate a particular P/E figure, chart, or report.
Like many other indicators, P/E is best viewed over time, looking for a trend.
A company with a steadily increasing P/E is being viewed by the investors as becoming more speculative.
And of course a company’s P/E ratio changes every day as the stock price fluctuates.
The P/E ratio is commonly used as a tool for determining the value of a stock.
A lot can be said about this little number, but in short, companies expected to grow and have higher earnings in the future should have a higher P/E than companies in decline.
For example, if a company has a lot of products in the pipeline, I wouldn’t mind paying a large multiple of its current earnings to buy the stock. It will have a large P/E.
I am expecting it to grow quickly.
A rule of thumb is that a company’s P/E ratio should be approximately equal to that company’s growth rate.
PE is a much better comparison of the value of a stock than the price.
A 10 stock with a PE of 40 is much more “expensive” than a 100 stock with a PE of 6.
You are paying more for the 10 stock’s future earnings stream.
The 10 stock is probably a small company with an exciting product with few competitors.
The 100 stock is probably pretty staid – maybe a buggy whip manufacturer.
It’s difficult to say whether a particular P/E is high or low, but there are a number of factors you should consider:
It’s useful to look at the forward and historical earnings growth rate.
If a company has been growing at 10% per year over the past five years but has a P/E ratio of 75, then conventional wisdom would say that the shares are expensive.
It’s important to consider the P/E ratio for the industry sector.
Food products companies will probably have very different P/E ratios than high-tech ones.
A stock could have a high trailing-year P/E ratio, but if the earnings rise, at the end of the year it will have a low P/E after the new earnings report is released.
Thus a stock with a low P/E ratio can accurately be said to be cheap only if the future-earnings P/E is low.
If the trailing P/E is low, investors may be running from the stock and driving its price down, which only makes the stock look cheap.