If you have ever watched a financial news or discussion program on television or picked up a copy of the financial section of a daily newspaper, then you know you have entered another world with its own language and terminology. To the uninitiated it often seems as if the stockbrokers, financial consultants, and market watchers are always speaking or writing in some hidden code. Even the most common terms like bonds, yields, dividends, annuities, etc. , can leave a person feeling obtuse. It’s almost as if the financial professionals want to keep the minions at arm’s length ” the “you’re going to need me- attitude!Indeed, with the current widespread interest in the stock market (and the many personal losses suffered by enthusiastic amateurs), we certainly do need to have a sound understanding of the many specialized terms. One term used in the world of stock investment that is used quite frequently is “Price-to-Earnings Ratio- or P/E ratio. As with the other terms mentioned previously, most people do not really know what a P/E ratio is. In this short essay I will attempt to explain what it is and how it applies to making wise investments.
The price/earning ratio is defined as the price of a share in a company’s stock divided by the company’s earnings per share. If, for example, a company’s stock sells for $50 per share and its earnings are $5 per share, the stock’s P/E ratio is 10 ($50 • $5 = 10). To simplify this definition, consider the following: A company is in business to make money. This is called “profit. “” Investors finance the company’s operations by supplying it with money ” their money! This is called “capital. “” Investors do this by purchasing “shares- which are simply units of capital.Just as the company expects to make a profit, the investors expect to reap a financial return on their investment, which is called a “dividend.
“” The so-called P/E ratio therefore is a basic indicator of the investors “value-for-money. “” Most people are not directly involved in day-to-day stock market activities. Their investments are tied up in their retirement funds, mutual funds, insurance programs, etc. , which are handled for them by professionals.
However, just about everyone has a bank account. A savings account is also a form of investing.Imagine every dollar deposited to be a share, and the interest credited to the account every quarter to be the dividend. In this case, the P/E ratio for the depositor would be around 400 ” which is not very good at all. This is because a savings account at the bank offers a very low rate of interest. A company’s per-share earnings are simply the company’s after-tax profit divided by the number of outstanding shares. Here is an example of a company’s per-share earnings: a company that earned $5M last year, with a million shares outstanding, had earnings per of $5 per share.
If that company’s stock currently sells for $50 a share, it has a P/E ratio of 10. Price/earning ratio is perhaps the single most widely used factor in assessing whether a stock is overpriced or a great buy. A company’s P/E ratio should be compared to those of similar companies, and with the market as a whole. Companies with high P/E ratios (of 20 or more) are often young, emerging companies. They may not have significant earnings yet, but investors are willing to pay a high price for the stock because they expect the company to grow.High-tech companies often trade with P/Es above 40, or about double the overall market P/E, whereas big established companies, such as banks and industrial giants, that already have substantial earnings usually have lower ratios.
Determining whether a particular P/E is high or low is difficult, and often a matter of judgment. Before making any decisions about investing in a company there are a number of factors to be considered. First, look at the forward and historical earnings growth rate. Second, consider the P/E ratio for companies in the same sector (e. g.
Wal-Mart will probably have very different P/E ratios than Microsoft). Then finally, a stock could have a high trailing-year P/E ratio, however if the earnings rise, at the end of the year it will have a low P/E after the new earnings report is released. This means a stock with a low P/E ratio is cheaper only if the future earnings P/E is low. Just like many other things, P/E ratios are best viewed over time, with a lookout for a trend.
A company with a steadily decreasing P/E is viewed by the investment world as becoming more convincing. And of course a company’s P/E ratio changes every day as the stock market fluctuates.