“What the heck…” is an ongoing series within The Pay Me Plan Blog for Investing Novices where I dissect a financial concept or principle, and explain how it can apply to your investing activities. In this post, we’ll be covering what a P/E ratio is and how it works.
In the P/E ratio, the “P” stands for price and the “E” stands for earnings. Thus, the P/E ratio means the price to earnings ratio. This is a metric used when evaluating the price of a public company’s stock in relation to how much net income the company is actually generating. We arrive at the P/E ratio by dividing a company’s stock price by its earnings. Here’s the basic formula:
Stock Price ÷ Earnings per Share = Price to Earnings Ratio (P/E Ratio)
The price of a stock is simply its price per share. For example, if XYZ stock is trading at $35 per share, then its price is $35. Pretty simple, right? Earnings are only slightly more complicated…
ARRIVING AT EARNINGS (THE “E” IN P/E RATIO)
A company’s earnings are simply the amount of net income the company generates over a given period. Earnings are usually reflected as earnings per share (often called “EPS”), which is calculated by taking the net income number and dividing it into the total number of outstanding shares. For example, if XYZ company earns $50 million and has 20 million shares, then XYZ earned $2.50 per share ($50 million ÷ 20 million shares = $2.50 earnings per share). Earnings per share is a metric that is frequently tracked, monitored, referenced, and studied in the financial community. Once we have arrived at the EPS number, now it’s possible to calculate the P/E ratio.
Continuing with our example of XYZ company, let’s calculate the stock’s P/E ratio.
Stock Price: $35.00
Earnings (EPS): $2.50
$35.00 (stock price) ÷ $2.50 (EPS) = 14 P/E Ratio
We see that XYZ stock currently has a P/E ratio of 14. But what does this mean to us as investors?
DETERMINING VALUE USING THE P/E RATIO
As investors, we like buying assets when they’re “on sale” (have a look at this blog entry where I explain why that’s the case), and the P/E ratio is a metric that can help us determine if an investment’s price is undervalued or overvalued. Yes, that little number can really tell us quite a bit. Let’s talk about application of the P/E ratio.
Looking at the historical data of the broader stock market over the last few decades, we can surmise that a P/E ratio of less than 10 usually means that a stock is relatively “cheap”, a P/E ratio of 10-20 usually means that a stock is “fairly valued”, and a P/E ratio of over 20 usually means that a stock is relatively “expensive”.
Now, that previous statement was a sweeping generality and there are definitely exceptions and other factors to be considered. For example, if we’re talking about a company that’s on a ballistic growth curve with immense earnings expansion, then that company could justify a higher P/E ratio because the expectation is that its earnings will grow rapidly in the months and years ahead. In contrast, if we looked at a slow-growing, stable business like a local electric utility, we’d expect a lower P/E ratio because the company’s earnings are regulated and thus grow very slowly. So when you’re looking at a company’s P/E ratio, be sure to keep the nature of the company’s operation in mind because it can definitely impact the stock’s valuation.
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Let’s start pulling this all together. Once we’ve got the P/E ratio, we can compare the figure to the company’s industry peers as well as the company’s historical P/E ratio to help us determine if the stock is attractively priced. If the current P/E ratio is 11, but historically it’s been over 25, and the company has been steadily growing its earnings over the last few years, then maybe this stock deserves a second look because we could have an undervalued asset on our hands.
Following that same school of thought, P/E ratios of individual companies are often compared to the P/E ratio of the S&P 500, which is a hand-picked basket of large, public companies that hail from a diverse array of industries. By comparing the two P/E ratios, we can also get an idea of how attractively priced an individual company is compared to the rest of the broader market.
In all fairness, most major financial websites such as Yahoo! Finance, Morningstar, CNBC, and MSN Money calculate the P/E ratio for you. They take the company’s earnings per share and divide it into the stock price to save you from doing the math. Nevertheless, comprehending what this ratio means and how it’s used in calculating a stock’s valuation is important in assessing a potential investment.
Those are my thoughts. Feel free to share some of yours below. Thanks for reading and as always, make it a great day.
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