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What in the world
is a P/E Ratio?
By Laura
Bruce • Bankrate.com
Part 1 of 4 in a series shedding light on the most
useful stock-valuation tools
The P/E (price to earnings) ratio is the most fundamental
piece of information you need to know about a stock, mostly because
it helps you determine if the share price is too high, too low,
or just right. The p/e ratio, which is also called the "earnings
multiple" or just "multiple," tells you what it costs to buy a dollar's
worth of earnings in a particular company.
Getting a P/E is easy. For one thing, it's listed
in the stock tables of any decent newspaper, and it comes up when
you get a stock quote online. Or you can figure it yourself: simply
divide the share price by the earnings per share (EPS). If IBM's
share price is $100 and it earned $4 a share over the last year,
the P/E is 25. That means the price of a share of IBM is 25 times
trailing annual earnings and that for every dollar of those earnings,
investors pay $25.
But the question is whether that $25 represents a
good deal.
A share of stock means actual ownership in a company
-- a portion of its furniture, brand name, real estate, patents,
etc. But you don't really want to own the two deep fryers that your
shares in McDonald's (NYSE: MCD)
represent. So what do you actually buy when you purchase stock?
Earnings. The currency a company needs to do the things that will
increase its stock price -- grow itself, buy back shares, pay higher
dividends, or make acquisitions.
Thus, the golden rule (drum roll, please): The goal
of stock investing is to find companies whose future earnings can
be bought today for less than the future earnings of other companies.
The P/E is an effective tool because it allows apples-to-apples
comparisons for stocks that vary greatly in price. Without it, a
stock like Berkshire Hathaway (NYSE: BRK-A),
which trades for $60,000 a share would be tough to compare to a
stock like Lucent (NYSE: LU),
which trades just under $60. Because both companies have a P/E around
50, a dollar of earnings from each company actually costs about
the same, despite the obvious difference in share price.
You can tell a lot about how investors feel about
a stock by comparing its P/E to the average P/E of the market. For
example, the P/E of the S&P 500 as a whole is 22. So the market's
telling you that it expects BRK.A and Lucent to grow its earnings
at about twice the rate as the S&P 500. By comparison, a company
like Xerox (NYSE: XRX),
looks like a bargain since its $26 share price suggests a P/E of
only 24. Then there's a company like Ford (NYSE: F),
where you can buy a buck of earnings for under $9.
Generally, the higher the P/E, the higher the growth
expectations. For many companies, especially those in hot sectors
like tech, Internet, biotech and telecommunications, the growth
expectations are so high and the earnings may be so low -- or non-existent
-- that the P/E is irrelevant as a barometer. Ebay's (Nasdaq: EBAY)
P/E is over 1,400. That means investors pay $1,400 for every dollar
of earnings. Investors are clearly pinning their hopes on incredible
future growth. Because different industries generally face different
expectations, P/E ratio is most useful for comparing a company's
stock price to that of others in its industry.
A low P/E doesn't always mean a better value, for
two reasons.
-
P/E is a backward-looking measure. Because
it uses last year's earnings, its usefulness in predicting
future earnings growth is limited.
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Some companies deserve a low P/E.
They may look like bargains because they're selling their buck
of earnings for cheap. But if the market thinks the company
will be hard pressed to grow those earnings, or even tread water,
the stock price will probably stay low.
Remember, the goal is to find companies whose future
earnings will cost you less today than those of other companies.
There are only two ways to do that. You can either buy companies
whose current price is lower than it "should be" or buy those whose
future earnings will be higher than expected.
-- Posted: June 21, 2000
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