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What is P/E ratio?
Dear Dollar Diva,
What is a stock's P/E ratio?
The P/E ratio is used by stock analysts and investors
to determine the valuation of a stock.
If the P/E ratio is high, the stock has a high valuation
-- investors are willing to pay for it because they expect high
future returns. To calculate the earnings-per-share of stock, divide
the company's net earnings by the number of shares in the hands
of the investors.
Price
The price is how much you have to pay to own a share
of stock. It's set by investors and is based on their expectations
of future growth of the company, the industry, inflation and the
overall market. A company's stock will jump in price if it announces
a merger, and investors believe that the merger will increase the
company's future earnings. If investors believe the merger will
inhibit the company's future earnings, the price will drop.
Earnings
Earnings are the bottom line -- a corporation's revenue
minus all of the expenses it incurred to bring in that money --
including interest, taxes and any other costs. The financial mission
of every for-profit corporation, such as Microsoft and General Electric,
is to generate earnings for its shareholders. A company fails when
it doesn't make money for its shareholders.
The financial mission of a nonprofit corporation,
like The United Way and your local homeowners association, is to
spend all of its income on its social mission. If it doesn't, it
fails.
Price/Earnings
In 1982, the S&P 500 P/E ratio was about eight.
That means the price of the stock was eight times its earnings.
In 1998, the P/E ratio was about 28 -- the price of the stock was
28 times its earnings. Investors in 1998 expected lower inflation
and higher net earnings than they did in 1982.
In “What
is market capitalization," the Diva presented a table showing
the correlation between the growth predictions for a company and
its P/E ratio. In it, American Online Inc., with a P/E ratio of
177 was expected to have annual growth of 50 percent; Merck &
Co., with a P/E ratio of 30 was expected to have annual growth of
12 percent.
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-- Posted: Feb. 16, 2000
DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting,
from the Kellogg Graduate School at Northwestern University in Evanston,
Ill. Rosen has more than 15 years of experience in the financial arena, serving
in Illinois and Florida as a certified public accountant, financial consultant,
expert witness and educator. She is owner of Dorothy Rosen, CPA, a public
accounting firm that serves individuals and small businesses.
