Price Earnings Ratio Explained
The price earnings ratio is calculated by dividing the share price of a stock by its earnings per share. For example, XYZ stock is priced at $20.00 a share. The company has earnings of $2.00 per share. The P/E ratio is 10. Earnings per share is calculated by dividing the stock's share price by the number of outstanding shares. In the example, investors are willing to pay $10 for every $1.00 in earnings.
What does the P/E ratio tell you about a stock? It lets you know how much others are willing to pay for a stock's earnings. In other words, it indicates whether a stock is expensive or not. A high P/E could mean that the stock is expensive. Conversely, it could simply be the normal valuation for a stock in that industry. This is why you cannot rely on the P/E alone.
Growth industries, such as technology, typically have high price earnings ratios. These types of companies are fast growing. Investors expect higher future earnings. Contrast technology to utilities. Here the companies are large, well-established, and slower growth. Their earnings will occur steadily. A lower P/E is normal.
You do not want to compare industry to industry. Instead compare within industries. A comparison across industries can lead to very wrong conclusions. Say a tech company like Google was compared to a utility like Verizon. One has a P/E ratio of 30 while the other is 17. You may conclude that the company at 30 was too expensive and the company at 17 undervalued. But, instead, they could be at their respective industry averages.
Price earnings ratios can be trailing, current, or forward. Trailing P/E is what you see listed most often. It is based on the earnings from the previous four quarters (year). Current P/E is used the least. It is based on an analyst's estimates of the current year's earnings. Forward P/E uses analyst's expectations of what the future year's earnings will be.
Trailing P/E will give you fairly-accurate information on how a stock has performed. Why fairly-accurate? That is because a company can use a number of accounting methods to alter the earnings numbers it had. This makes calculations you assumed were hard facts a little shaky. This is one good reason to not base a stock pick on just the price earnings ratio.
The other problem with trailing P/E is that it represents the past. The future is where we invest. Forward P/E gives an idea what the future value and growth of a stock will be. The problem is that the future expectations could be way off and earnings growth doesn't occur.
The price earnings ratio can act as one of many guides when choosing a stock. It is used to evaluate the entire market with the United States stock market averaging a P/E of 15. Just remember to keep it in context with other factors.
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