Understanding Price to Earnings Ratio

With Price to Earnings, Being In the Know Can Make You Dough

Green stock market ticker board numbers
Green stock market ticker board numbers/ Phtoographer's choice/ Getty Images

Some stock watchers, especially the novices, tend to fixate on numbers that the headlines dish in the blink of an eye: share price, the Dow Jones and S&P numbers and the IPOs of high-techs.

But if there's one number that people need to look at than more any other, it's the Price to Earnings Ratio (P/E). But what does that mean, anyway? Wall Street loves its jargon the way former President Bill Clinton loved his hamburgers.

And indeed: Among the Wall Street cognoscenti, P/E is one of those numbers investors throw around with great authority. But it doesn’t own the stats board. (Otherwise, all the other numbers wouldn't matter.)

In a nutshell, here's how P/E works:

1) The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider.

2) You calculate the P/E by taking the share price and dividing it by the company’s EPS.  That's "earnings per share," to de-jargonize another term. (Go ahead: Thumb your nose at that hedge fund guy and shout, "My NIK factor is up 100 percent ... as in "now I know.")

3) The formula: P/E = Stock Price / EPS

For example, a company with a share price of $40 and an EPS of 8 would have a P/E of 5 ($40 / 8 = 5).

What does P/E tell you? The P/E gives you an idea of what the market will pay for the company’s earnings.

The higher the P/E the more the market will fork over. Some investors read a high P/E as an overpriced stock. That may be the case. But it can also indicate the market has high hopes for this stock’s future and has bid up the price.

Caution, though: It's often hard to tell the difference between high hopes and "irrational exuberance."

A low P/E may indicate a “vote of no confidence” by the market ... or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these “diamonds in the rough” before the rest of the market discovered their true worth.

What is the “right” P/E? The answer depends on your willingness to pay for earnings. The more you are willing to pay--which means you believe the company has good long term prospects over and above its current position--the higher the “right” P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your “right” P/E is all wrong. 

Confused? Fear not. But see how this works? Even the experts often puzzle over how to pick stocks based on P/E. In the end--and we can't stress this enough--EVERY COMPANY IS DIFFERENT. To borrow from baseball, no one would confuse the New York Yankees with the Houston Astros, and that comparison changes from season to season.

(Apple (AAPL) which was an innovator in Steve Jobs' day, is a caretaker company in 2016 battling against slumping iPhone sales.)

So for every company you scout for P/E, follow it carefully. Learn what you can about its management team, its place in a given sector (e.g., energy, high-tech, pharmaceuticals) and the opinions of expert analysts. Turn your P/E knowledge stash into potential investment cash. 

Other articles in this series include:

  1. Earnings per Share – EPS
  2. Price to Earnings Ratio – P/E
  3. Projected Earning Growth – PEG
  4. Price to Sales – P/S
  5. Price to Book – P/B
  6. Dividend Payout Ratio
  7. Dividend Yield
  8. Book Value
  9. Return on Equity

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