The Price to Earnings Ratio
Jim Graham

When most investors think about the fundamental value of a company, they usually think of the price to earnings ratio. The P/E ratio tells you how much you are paying for each dollar of a company's earning (profit). It is popular because it's easy to understand, but in some situations it can be misleading and is not a substitute for real fundamental research. Still it is a useful tool for valuing an individual stock and can also be used to help you form an opinion on the likely future direction of the stock market as a whole.

Understanding the Price to Earnings Ratio

The P/E ratio is simply a mathematical calculation. It is the current price of one share of stock divided by earnings per share.

The first thing to understand about the P/E ratio is that it is designed to value a share of stock, not a company, and stocks are priced per share. The P/E ratio tells you what the market is willing to pay right now for anticipated future earnings, assuming that the earnings remain constant into the future. A stock that has a P/E ratio of 15, for example, tells you that it will take 15 years of the company's earnings at the current rate to add up to your original purchase price.

To see if a stock is over- or under-valued, the first step is to compare its current P/E ratio to its past P/E ratio. This will give you an idea of how cheap or expensive the stock is relative to the how it has been valued in the past.

The next step would be to compare its P/E ratio to the ratios of other companies in the same industry. Companies in the same industry tend to have similar P/E ratios. If it is considerably higher or lower than its peers, you will want to do additional research to see why that it is.

When the P/E ratio is Low

Low-P/E stocks are not necessarily a good value. If you were to buy a few stocks with low P/E ratios you may soon discover the reasons they were so cheap. A low P/E ratio usually indicates that investors expect little to no growth in a company's earnings in the future, or possibly even a drop in earnings in the future.

Companies in some industries, homebuilders for example, historically have very low P/E ratios. So a home builder that you see with a P/E of 10 might actually be an all-time high for that company indicating it might be overvalued. It is only when comparing its P/E ratio with its peers in the same industry that you can see how a company is valued compared to other companies in its industry.

Rather than indicating a bargain, an extremely low P/E ratio is often a sign of financial trouble or other problems with the company or industry. Investors using the P/E ratio to find potential bargains, often called value investors, must follow up and do extensive research to completely understand the company and the industry it operates in before making any investment. In fact, if you were to buy all low P/E stocks without further research, you would probably just end up with a portfolio of underperforming stocks.

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