I Liked PE In School, But Don't Understand It Now That I'm Investing. What Is The Price To Earnings Ratio?

Let’s talk for a minute about a key measure of stock value, the Price to Earnings Ratio or P/E.

Yes, yes – you were told there would be no complicated formulae, rituals or incantations involved in growing your nest egg. But the P/E isn’t all that complicated and it’s a pretty handy tool for assessing possible investments, and for impressing people at the bar when the conversation turns from sports to the hot stock du jour.

The P/E is simply the ratio of a stock’s current selling price to the company’s recent earnings per share (EPS), typically over the past four quarters. If Acme Industries shares are currently trading at $30 and its EPS is $2, the P/E would be how much? Come on, you know this. Right. 15.

The P/E can help determine whether a stock you are considering is “expensive” or “cheap.” When you invest, you want to buy into companies that have strong earnings, or the near-term prospect of strong earnings. And, ideally, you want to pay as little as possible for those earnings. In the Acme example above, you are paying $15 for every dollar of earnings that you buy.

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Whether a P/E is “good” or “bad” depends on several factors, including the company’s growth rates – past, present and expected. A stock’s P/E reflects the market’s level of confidence in the company. A P/E above the market or industry average is a sign that the market is expecting significant success and earnings growth from the company in the near term.

But the P/E isn’t perfect and should not be the sole measure of a possible investment. For example, beware of a stock with a high P/E despite low recent growth. Something isn’t right in that situation. The stock may, for example, be benefitting from unjustified media hype or Wall Street buzz. Similarly, a stock might be considered over-priced if its current P/E isn’t supported by analysts’ projections for the company’s future growth.

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Industry norms must also be weighed when assessing a P/E. You can’t really compare the P/E of two companies in different categories; such as a utility and a start-up tech firm. The P/E ranges for those industries are wildly different. Utilities are stable, low-growth operations and tech firms experience wild growth and constant upheaval.

There, that wasn’t too painful, was it? And now you’ve got another tool to help make smart investment decision – or to at least better understand the decisions you’ve entrusted to your financial advisor.