How to calculate and use Price/Earnings ratios (PE ratios)
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Market Investing Strategies
You would’ve been told often enough that stock prices are driven by the earnings, both historical and prospective, of a particular company. One of the most popular metrics used in valuing stocks is the Price/Earnings ratio or the PE ratio. It is an easy ratio to calculate but not as easy to understand and investors often tend to rely on the ratio blindly. It is not a magic formula and it is important to understand the limitations and when it should not be used. As the name suggests, it is calculated by dividing the current stock price by its earnings per share (EPS).
The P/E ratio is often calculated by taking the historical EPS for the last four quarters and this is referred to as a “trailing” P/E ratio. When you use projected or forecast EPS for future quarters, it is called a “forward” P/E ratio. Some people use a mix of historical and projected data. What you should keep in mind is that historical data is accurate whereas projected data, which is often based on the estimate of analysts, is an educated guess. When a company is losing money and has a negative EPS, experts differ on how the P/E ratio should be calculated. Some experts calculate a negative P/E ratio whereas others assign a value of zero meaning that there is no P/E ratio because there are no earnings.
In theory, the P/E ratio tells us how much an investor is prepared to pay for every dollar of earnings of a company. This is why it is also called a “multiple” in investing jargon. You might hear investors say “I am prepared to pay a multiple of 20 for ABC Corporation” which means that if the EPS is one dollar per share, they would be prepared to pay a P/E ratio of 20 which translates into a price of $20 per share. In actual stock market trading, this is a simplistic view because the stock price has to be discounted to take into account the future earnings prospects. So a good way to look at the P/E ratio is to look on it as an indicator of market sentiment for that particular stock.
For instance, hot stocks or stock is regarded as hot growth prospects will always have a P/E ratio that is higher than the average for the industry. However, the company has to meet earnings expectations which become more difficult as the company grows. As a result, P/E ratios tend to drop as the company matures and this has been proved by software stocks like Microsoft where the P/E ratio has halved as earnings have stabilized. P/E ratios are also useful in deciding between two alternative investments. If everything else is equal, a $10 stock with a P/E ratio of 100 is regarded as “expensive” whereas a $100 stock is regarded as “cheap”. You can buy either of them for $1000 a share but the difference in perception comes from the differing P/E ratios. The cheap stock will find it far easier to fulfill investor expectations than the expensive one.
Tags: earnings multiple, earnings per share, eps, Investing, pe ratio, Stock Market, Stock Market Investing