The Price to Earning Ratio (P/E) also known as Earnings Multiple or simple Multiple is the great equalizer.
In the world of investing there are a multitude of metrics that are used to determine if a stock is a good pick. No one measurement or statistic should be used to make the final decision. However, the PE ratio should be one of the metrics you use.
Put simply P/E ration is the Price of the stock relative to the company’s earnings. If a company’s stock is sold for $10 and it is generated $1 in profits, the P/E ratio, or multiple is 10 (Price / Earning = Multiple). Conversely, you can use the P/E ratio to determine how much a company is earning (Multiple * Price = Earnings). A stock with a P/E ratio of 20 that sells for $5 is earning $.25 per share.
P/E is the great equalizer because it provides a baseline for comparison to determine if the stock in question is cheap or expensive relative to the rest of the market. All things being equal, you would want a stock with a lower P/E ratio which would then give you more opportunity for profit. “All things being equal” is the key language in the preceding sentence, because rarely are all things equal.
If a company is expected to enjoy market leading growth over the next several quarters the market will usually bid up its share price and therefore its P/E ratio. A company that is not performing well will generally have a lower P/E ratio. And companies that have no earnings or lose money will not have a P/E ratio because there are no profits to calculate.
Confusing, maybe, but P/E ratio is important because it lets you determine the relative value of a company. Company A will have a stock price of $1 while company B will have a stock price of $100. Which is more expensive? You don’t really know until you learn how profitable they are so that you can determine the P/E ratio.
Company A makes $.05 per year, while Company B makes $10 per year. Using Price / Earning = Multiple we find that Company A at $1 divided by $.05 = 20 P/E while Company B at $100 divided by $10 = 10 P/E. Even though Company B has a $100 price tag per share it is actually a cheaper stock to buy, relative to earnings. All other things being equal Company B might be the better choice.
“All things being equal”…
Unless otherwise noted P/E ratios are based on the most recent trailing 12 month period of earnings. In some cases you will see websites and statistics represent a “Forward” P/E ratio. In these rare cases the ratio is based upon expected earnings in the coming 12 months as determined by a group of market analysts.
Before you buy a stock there are many other factors that you may want to consider such as the PEG, EBITDA, Dividend and its Yield, Book Value to name just a few. Additionally, it is prudent when picking stocks to understand the company, its products and its market as well. No good investor would risk their money in something they don’t know. That would likely just be a waste.