There are different ways to measure how “expensive” or “cheap” a stock is. One way to measure this is the P/E or price-to-earnings ratio.
How to calculate P/E ratio?
To calculate the P/E or price-to-earnings ratio, you divide the price per share of a stock by the earnings per share. Historical (trailing) earnings can be used or projected (forward) earnings. For example, if a stock is trading at $80/share and in the last 12 months earnings were $4/share, then the historic (trailing twelve months) P/E ratio would be 20 (80 / 4 = 20).
Another way to think about P/E ratio is how many years it will take for you to earn your investment back, assuming earnings do not change. So in the example above, 20 years of $4/share earnings would equal your $80 investment (20 * 4 = 80). Of course, earnings will almost never stay exactly the some. Regardless, it is a helpful way to think about what the ratio means.
Remember that a stock is a small piece of a business
As previous posts have emphasized, remember that a stock is a small piece of a business. If you were purchasing a small business, you would want to know how much the business earned last year and how that income relates to the price you are paying. Similarly, the P/E ratio creates a consistent measure that can be used to quickly look at how expensive a company's stock is, and to compare it to other stocks.
A lower P/E isn’t always better
If a stock A has a P/E of 10 and stock B has a P/E of 30, which one would you rather buy? 10-year payback (assuming no change in earnings) vs. 30-year payback (assuming no change in earnings). Seem like an easy decision, right?
However, there might be good reasons why stock A is so cheap. Maybe earning are about to plummet, maybe new competitors are entering their industry, maybe the company just lost a major lawsuit. On the other hand, there might be good reasons why stock B is so expensive. A common reason why “expensive” valuations can be justified is rapid earnings growth – earnings will be a lot higher in a couple of years, so the high price now will be small when compared to those future earnings. The P/E ratio doesn’t magically show you which stocks to buy, but it still is a useful measure to quickly evaluate the price of a stock as compared to its earnings.
P/E ratio is a popular metric
Similar to market capitalization, which we discussed in a previous post, P/E ratio is one of the first metrics listed when looking up a quote for a company’s stock. Here are two examples of different finance websites (Google Finance and Yahoo Finance) and their metrics for Exxon Mobil (symbol = XOM):
As you can see, the P/E Ratio of Exxon is 7.16. The “TTM” stands for “trailing twelve months.” As described above, the ratio is calculated by dividing price per share by trailing earnings per share.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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