Understanding P/E Ratios

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Before making an investment, investors should research the different metrics that companies provide as the calculations will help them select the best type of investment for their situation. The five most commonly encountered metrics for the value investor are the P/E (price/earnings) ratio, P/B (price/book) ratio, Debt/Equity (which for reasons unknown is not typically given an acronym) ratio, free cashflow, and the PEG (price/earnings to growth) ratio. Of those, the price-to-earnings, or P/E, ratio is the most important investment ratio to consider when choosing to invest.

About P/E Ratio

To calculate the ratio, stock analysts take the share price and divide it by a company’s earnings per share. The resulting number is a measure of the price that is being paid for the earnings. For instance, if a company is currently trading at $50 a share and over the last year, its earnings were $2.00 a share, then the P/E ratio for the investment would be $25.00. Furthermore, when a P/E ratio is high, the earnings are also high.

Keep in mind that the P/E ratio does not give investors a complete picture of the stock’s cost. To understand how much a stock is going to cost an investor, he or she will need to look at the potential investment’s industry or a broad market index like the S&P 500 or Dow Jones Industrial Average.

Relationship with Value

The core idea of the P/E ratio is extracting a single number that relates the price of a stock with the amount of value that a stock will generate, typically through revenues. When investors access a stock website such as Google Finance, MSN Money or Yahoo Finance, they’ll find the P/E ratio on each site’s main page. If the P/E ratio is a low number, then you can interpret that to mean that you are able to get a good value on the stock. Before investing in a stock, even if your advisor has recommended it, be sure to compare the P/E ratio of a tempting investment against stocks in the same sector. For instance, don’t compare Wal-Mart stock against Google stock as the companies perform in different industries. Instead, investors should review Target stock if they are considering an investment in Wal-Mart.

Details to Remember

In most cases, a high P/E ratio means that financiers are expecting future growth of the stock. Typically, the average market price to earnings ratio is usually 20 to 25 times the company’s earnings. If the P/E ratio is much higher than that then you should have a strong justification for buying. A low P/E ratio is not necessarily a cause for alarm, however; many solid income stocks such as utilities will have a low P/E ratio yet are still solid stocks because while their revenues are tied to a captive market their potential losses are similarly constrained. When a company is losing money, it will not have a P/E ratio listed. Also, the calculation may use estimated earnings to acquire the future P/E ratio number. By reviewing the P/E ratio of other stocks in the same category, investors can better assess the performance of their preferred investment, but it shouldn’t be relied upon as the sole factor in any investment decision.

Jim Friedman is a personal finance writer from Saskatoon.  Read more of his work at http://www.getreasonablywelloffslowly.com

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