Fundamental Analysis: Understanding Price To Earnings Ratio

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Fundamental Analysis: Understanding Price To Earnings Ratio

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In the world of fundamental analysis, there is one undisputed star — the Price to Earnings Ratio or P/E.  This is the number that every talking head, on every stock story, on every financial news show uses to demonstrate how smart they are.

The Price to Earnings ratio is also the “headline number” that is attached to most financial reporting. It is tempting to look at that number — that headline — and come to a conclusion about the health of a company and the value of its stock relative to that perceived health.  It is perhaps the number one mistake that investors make when trying to determine if a stock is a good buy or not.

But the fact is, though a company’s Price to Earnings Ratio may be easy to calculate, it is not nearly as easy for an investor to interpret.

The formula for P/E is pretty straightforward and can be calculated as so;

Stock Price / Earnings per Share = Price to Earnings.

So as an example, if a company has a stock price of $50 and an EPS of $5.00 then the P/E would be 10.

Yeah, so what does that mean?

The P/E tells you how the market is valuing a company and what investors are currently willing to pay for it.  In fact, it is often referred to as a “multiple” because it shows how much per dollar of earnings investors are willing to pay. A company with a trailing P/E of 10 means that investors are willing to pay $10 for every $1 of current earnings.

In some cases, a high Price to Earnings Ratio is seen as evidence that a stock is overvalued, though in some circumstances it may mean that future earnings growth is expected by investors and they are will to “pay up” for it.

By comparison, when a stock has a low P/E it means that the market does not believe in the company.  However, the flip side to this is that the company may also yet to be discovered by investors or its future prospects undervalued.

Despite the amount of focus that the P/E ratio gets in the financial press, there are important problems that can arise from using it as your sole determining factor when analyzing a stock, most notably related to earnings.

Basing a metric heavily on earnings can be problematic because earnings are subject to various forms of manipulation, which makes the P/E ratio only as good as the quality of the earnings being used to calculate it.  Garbage in, garbage out.

As with any type of analysis, there is no “silver bullet.”  Using a basket of indicators or metrics to determine if a stock is a good buy is always the best practice.  See the following topics for more on fundamental analysis;

  • Earnings per Share – EPS
  • Projected Earning Growth – PEG
  • Price to Sales – P/S
  • Price to Book -P/B
  • Dividend Payout Ratio
  • Dividend Yield
  • Book Value
  • Return on Equity

As my series on fundamental analysis continues we will cover all those topics so you can get a well-rounded understanding of the process for picking winning stocks.