Understanding the stock market – The P/E ratio
If you’ve ever read anything about the stock market I am sure you would have heard the term P/E ratio. This term stands for price earnings ratio and when it comes to valuing stocks it is one of the oldest and most frequently used metrics.
Although it is a simple indicator to calculate it can actually be quite difficult to interpret. In some situations it can be informative and in others it is meaningless, and because of this investors often misuse the P/E ratio.
The P/E ratio is the ratio of a company’s share price to its per-share earnings. To calculate it you just divide the market value per share by the earnings per share (EPS). The P/E ratio will usually be calculated using EPS from the last four quarters (known as trailing P/E). it can also be calculated using estimated earnings over the next four quarters (known as leading or projected P/E).
After you have calculated the P/E ratio there are a number of different ways in which you can use it. Theoretically P/E tells us how much investors are willing to pay per dollar of earnings. A P/E ratio of 20 tells us that investors are willing to pay $20 for every $1 of earnings. P/E can also be seen as a reflection of the market’s optimism concerning a company’s growth prospects.
If the company has a higher P/E that the market or industry average it means that the market is expecting big things over the next few months or years.
The P/E ratio is a much better indicator of the value of a stock than market price alone. All things being equal a $10 stock with a P/E of 75 is much more expensive than a $100 dollar stock with a P/E of 20. Just remember that there are limits to this form of analysis you can’t just compare the P/Es of two different companies.
A common mistake that beginner investors make is the short selling of stocks because they have a high P/E ratio. Valuing a stock based solely on a simple indicator like the P/E is a very bad idea and can get you into serious trouble.
So what have we learnt about the P/E ratio. Although it doesn’t tell us much it can be useful to compare the P/E of one company to another in the same industry, to the market in general or to the companies own historical P/E ratios. Analyzing securities requires a lot more than just understanding a few ratios, while P/E is one part of the puzzle it is not the be all and end all.