Price to Earnings Ratio - What is a Price to Earnings or P/E Ratio
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What is a Price to Earnings or P/E Ratio?
Price to Earnings Ratios Can Be Useful If You Know How To Use Them
By Dana Anspach, About.com
A price to earnings ratio, otherwise known as a P/E ratio, refers to the price you are willing to pay today, for every $1 that a
company either earned in the past year, or is expected to earn in a future year.
Price to earnings ratios can be useful, or misleading, depending on how you use the data. The following examples will help
you understand how to calculate P/E ratios, how they can lead you astray, and when they can be useful.
Calculating Price to Earnings(P/E) Ratios: WIDGET
Suppose you are looking at buying WIDGET stock, symbol WDGT. Here are the facts:
The stock is selling at $20 per share.
Last year, WIDGET had earnings of $1 per share.
Analysts estimate the company will earn $2 per share this year.
P/E ratio based on past earnings is 20. Calculation: $20/$1 = 20.
P/E ratio based on projected earnings is 10. Calculation: $20/$2 = 10.
This means you are willing to pay $10 for every dollar of projected earnings. This is also referred to as paying “10x”
earnings, or the stock is said to have quot;an earnings multiple of 10quot;.
Comparing P/E Ratios: GZMO
You compare WDGT stock to GIZMO, symbol GZMO. Here are the facts:
GZMO is trading at $10 per share.
Last year GZMO had earnings of $.50 per share.
Analysts estimate the company will earn $.60 per share this year.
P/E ratio based on past earnings is 20. Calculation: $10/$.50 = 20.
P/E ratio based on projected earnings is 16.67. Calculation: $10/$.60 = 16.67.
In comparison to WDGT, GZMO appears to be more expensive, as you have to pay more today for the same amount of
expected future earnings.
You buy WDGT.
The fallacy of P/E ratios when comparing individual stocks: WIDGET vs. GIZMO
The problem is the data is based on two things that have no relevance to what will really happen:
1. Past data. There is no guarantee the company’s products will continue to sell in the future as well as they have in the
past. Earnings can change.
2. Projected earnings. Analyst study past data, and consumer trends, but consumers are fickle, and new products can