Understanding the P/E Ratio

In  simplest terms, the P/E ratio is a way to value a company by comparing  the price of its stock to its earnings. This is done by taking the price  of a share of stock and dividing by the earnings per share.

Discovering the share price of a stock is simple to look up on any trading website.

Earnings per share is a bit more difficult since it is also a calculation. It is the total earnings of a company divided by the total number of shares outstanding.  This tells you how much each individual share earned. The company’s earnings are calculated historically, looking at average earnings over a set time period (past trailing 12 months, last fiscal year, etc.).

The  P/E ratio for a company is given on financial websites with its other  stock information (if there is no P/E ratio given, the company is not  profitable).

So, the main question is what does this number mean to you?

Generally  speaking, it is often assumed that a company with a high P/E is  over-valued (low earnings to high price) and not a good investment.  Conversely, a low P/E means under-valued (low price to high earnings) and a good investment.

Though this may true too, a high P/E ratio shows confidence and excitement in a company, that it will continue to grow, and may be a safer investment.

Or a low P/E may indicate investors are losing confidence and do not believe the company has much of a future.

The dream stock is one with a low P/E that is on the verge of increasing significantly, where public opinion may be incorrect.

The P/E value is helpful when comparing two companies in the same industry, it allows an investor to compare apples to apples. For example, if you have an older, established company in the same industry as a new start-up, stock prices alone don’t tell you much, but looking at their P/E ratios can give you good information on comparing the two companies.

When it comes to the market in general, the S&P 500 P/E ratio can be analyzed. Since the 1870’s the average P/E for the S&P 500 is about 17. Historically speaking, if the S&P 500 P/E is really high, it may not be the best time to invest in general because the market will eventually drop. A low S&P 500 P/E can indicate a good time to invest because the market will eventually rebound and grow. But this is a generalization, and each stock needs to be analyzed on its own merit.

The main thing to realize is that the P/E ratio is a great tool to use with other information when determining whether you wish to purchase a stock. The key being other information. On its own it may be rather misleading. But taken with other investing tools and information about a company, it can help you make the best decisions for you.