The Price / Earnings (P/E) Ratio

After finding the price of a particular stock, usually the next number everyone looks at is the P/E ratio.

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.)

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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.

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Like 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.

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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:

First:

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.

Second:

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.

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Finally:

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.

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