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  • 1. Price to Earnings Ratio - What is a Price to Earnings or P/E Ratio Money Over 55 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 http://moneyover55.about.com/od/howtoinvest/a/whatisperatio.htm?p=1
  • 2. Price to Earnings Ratio - What is a Price to Earnings or P/E Ratio easily change buying habits. Future earnings are not predictable. A few months after you buy WDGT, someone files a lawsuit naming one of WDGT’s well known products as a problem. People stop buying this product, and WDGT’s earnings go down. The stock price goes down too. GZMO, on the other hand, releases a new product that starts selling like hotcakes. GZMO’s earnings go up, and so does the stock price. Now WDGT is at $15 per share with $1.50 of earnings per share. It now has a P/E of 10. GZMO is selling at $15 per share with $.75 of earnings per share. It now has a P/E of 20. You decide that GZMO is growing faster, so you sell WDGT, realize your $5 per share loss, and buy GZMO. A year later, WDGT’s lawsuit gets dismissed. GZMO’s product, although popular, was a quick fad, and they had no more new products in the production line. WDGT’s stock steadily climbs to $25 per share. Their earnings rise to $2.25. GZMO’s stock drops to $9 per share. Their earnings go back to $.50. Because of constant changes, as described in the above examples, price to earnings ratios should not be used to determine if an individual stock is appropriately valued. Valuation of the Stock Market as a Whole: When P/E Can Be Useful Price to earnings ratios can be useful in looking at the valuation of the market as a whole. In the early 70’s, there was a group of stocks called the Nifty Fifty. They were the largest companies, and institutions bought giant sized positions of their stock. The P/E ratios of these companies got as high as 65-92. The market crash of 73/74 came along, and by the early 80’s, these same companies had P/E ratios of 9-18. It should have been plain common sense that no sizable company can grow fast enough to justify an earnings multiple of 80-90. The lesson wasn’t learned however, and the situation repeated itself in the late 90’s, with tech stocks. P/E ratios of the tech favorites routinely exceeded 100. The lesson to be learned: Abnormally high P/E, combined with exuberant headlines, can be a signal that the market is overheated and equity exposure should be reduced. Abnormally low P/E, combined with pessimistic headlines, can be a signal that equity exposure should be increased. For more on P/E read A Random Walk Down Wall Street1, by Burton Malkiel. This About.com page has been optimized for print. To view this page in its original form, please visit: http://moneyover55.about.com/od/howtoinvest/a/whatisperatio.htm ©2009 About.com, Inc., a part of The New York Times Company. All rights reserved. Links in this article: 1. http://moneyover55.about.com/od/howtoinvest/a/od/bookreviews/a/randomwalk.htm http://moneyover55.about.com/od/howtoinvest/a/whatisperatio.htm?p=1