Investment Tips: What Is A P/E Ratio?

The P/E ratio can be a powerful tool in assisting the investor with stock picks.

The P/E ratio is one of the most bandied about terms in finance, and indeed, it can be a useful tool in helping to determine whether a stock is right for the investor. But what is the P/E ratio? How is it determined? And, is it really as helpful as people make it seem?

The P/E in the P/E ratio stands for "price-earnings." It is calculated by taking a company's stock price and dividing that number by its earnings per share, also known as EPS. For example, if a company's stock price is $31.77, and their EPS (a number easily found on most analyses of a stock) is $.58, then the P/E ratio would be: 31.77/.58 = 54.78. This means that essentially the investor is paying $54.78 for every $1 that company's earns. This would be considered a rather high P/E ratio, as somewhere around 20 is considered average. A company with a high P/E ratio is sometimes referred to as "overvalued" while one with a low ratio is sometimes called "undervalued."

Whether a P/E ratio is high or low indicates a number of things to the investor, and can result from a variety of factors. First, the investor must determine whether or not the EPS has been derived from historical data or from anticipated data. This can make a big difference in the P/E ratio, and should be taken into consideration. Most of the time the value is calculated by using historical data - the last four quarters of reported earnings. Sometimes, though the data used is projected - meaning that the earnings used are what analysts expect the company to make over the next four quarters. This is obviously a much more risky way of figuring the ratio, because, as we all know, analysts predictions are often incorrect. If the data used is historical, and the P/E ratio is still quite high, this indicates to the investor that the market as a whole expects the company to have growth in the future, which is what pushes the stock price up in the first place. Having a high P/E does not necessarily mean the stock is worth as much as it is selling for. Companies can easily run into unforeseen problems at any moment, sending that EPS - and the stock price - through the floor.

In the same way, having an average P/E ratio, or even a lower than normal ratio, does not necessarily mean the company is lesser thought of by the market, but that the market doesn't think there is as much room for growth with that company. For this reason, newer, smaller companies and companies in the technology sector often have higher P/E's, because of the potential for growth in those markets. Larger companies and blue-chips often have more stable, lower P/E's, because they are closer to a maximum growth threshold. However, sometimes the market does believe that the company is headed for trouble - which would then drive the stock down and the P/E ratio (especially if the EPS is based on historical data) down with it.

The P/E ratio can be useful in comparing stocks, but should not be relied upon too heavily. Instead, it should be one of many factors that an investor looks at when considering potential stocks. The reason for this is that the P/E ratio can be affected by a number of factors which can skew the number one way or another. For example, the EPS, one of the keys to determining the ratio, is not stable, meaning that when you look at the EPS of one company the number may not be derived in the same way as that of another company. This is because earnings are reported differently by different companies, based on their accounting practices and sometimes, unfortunately, what they want the public to think. Without knowing exactly what numbers were used and in what way, two P/E ratios side by side - even from similar companies in the same industry - don't necessarily do the investor much good.

Although the P/E ratio has become one of the trendier terms in personal finance, it is important to realize that it is only one of a large number of items to take into consideration when purchasing a stock. Still, understanding what the ratio is, as well as its benefits and limitations, will provide the investor with another tool with which to build his or her portfolio.

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