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Understanding the P/E Ratio

You’re in the big game getting stared down by a pitcher who can throw a mean fastball. He’s spitting tobacco left and right, getting the signal from the catcher. You just know you’re either going to go down swinging at curves or let that home run pitch fly right on past you. Investing in stocks can give you the same feeling that you’re going to strike out, but if you make use of P/E Ratios, you can get a good eye for which investments to swing at and which to let breeze on by.

A P/E Ratio is your coach for hitting investment home runs. A P/E Ratio, or price-to-earnings ratio, is a piece of stock information telling what value investors place on a company. How exactly does this work? There are two components to a P/E ratio. The first is the price of the stock, while the second is its Earnings Per Share (EPS). The P/E ratio is literally the price of a share of stock divided by its EPS.

So what’s the big deal? It’s basically a reflection of the performance investors expect (but don’t always get) from a stock. Generally, investors assign higher P/E ratios to companies they expect to earn more rapidly than they do to companies from which they expect lower earnings growth.

Lets see how this works:

This is an example that illustrates the idea that companies with faster earnings growth usually (although not always) have higher P/E ratios because investors expect to get more money from them in the long run.

Why is this the case? Investing comes down to what you are willing to invest today in order to earn money in the future. Given all of the factors that impact stock prices, the bottom line is that P/E is a measure of what you’re willing to pay for a company’s future earnings. If you expect a company to grow earnings strongly, you pay more (and the stock will trade at a higher P/E). If you expect them to grow slowly, you will pay less for them and the stock will trade at a lower P/E.

You may also hear them called "earnings multiples" or "multiples." P/E Ratios are found by taking the price of one share of a stock and dividing it by that company’s earnings per share, or EPS. EPS is a company’s total earnings divided by the total number of shares outstanding. As an example, lets look at Exxon from above. In the year ending June 30, 2000, the company earned $11.3 billion. If you divide that $11.3 billion by the 3.93 billion outstanding shares of Exxon stock, you get an EPS of $3.25.

P/E Ratios hint at the pitch a stock is going to throw you. P/E Ratios are a great tool for doing a "value check" on stocks by telling you how much investment it takes for the company to build earnings. Earnings are the money a company needs in order to increase their stock price, and make the stock you buy now worth more in the future. When you invest in a company, you’re investing in the hopes that their earnings will be high and give your stock more value by raising its price or paying higher dividends, or money some companies pay to investors. Knowing the P/E Ratio will give you an idea of which stocks are jocks and which are the last picked for the team.

Buy and sell just like the pros!