Time to Make Cents

One aspect of the stock market that often befuddles novice investors is how stocks are valued. How is it that a company like Google has a stock priced around $380 (and be considered cheap by some) when Microsoft can have a stock priced around $27 (and be considered expensive by others). The reasoning behind a stock’s price can be quite extensive, but there is one important relationship that must be understood. That is, the relationship between a stock’s price and the company’s earnings (or profit). This relationship can be viewed by utilizing the Price to Earnings (P/E) ratio.

The P/E ratio indicates how much an investor would have to pay (by purchasing the stock) for each dollar the company has earned. The price to earning ratio is calculated by dividing a stock’s current market value by the company’s earnings per share (the profit of the company divided by the number of shares available in the company). There are different types of P/E ratios, based on the earnings used to calculate the ratio. For example, a P/E ratio can be calculated based of a company’s earnings in one quarter, or based off of the expected earnings for the future year (known as the forward P/E ratio). The most commonly used P/E ratio is the trailing P/E ratio, which utilizes the earning per share of the past year. The larger the P/E ratio, the more optimistic owners are of the company’s prosperity and future growth. It is now that one can understand what could make a five-dollar stock expensive and a 20-dollar stock cheap-- the price is all relative to the earnings per share!

The P/E ratio is a great tool to help define the true value of a stock, but it is not perfect. There are no magic “buy” and “sell” numbers to watch out for. To determine appropriate P/E ratios for a particular stock first look at the industry. The average P/E ratio will help put a particular stock’s P/E ratio in perspective. A stock that has a lower P/E ratio than the industry on average may be a good buy. Look at the stock’s average P/E ratio in general. A stock that is trading with a lower P/E ratio than the industry is of no special value if it on average trades below the industry P/E ratio average! Also, compare the stock’s current P/E ratio with current news and information you have about the company. Essentially, a low P/E ratio does not necessarily indicate a buy signal. A stock that is trading at it’s lowest P/E ratio to date is not a good buy if bad news is continually sending the stock’s price (and P/E ratio) sinking! Furthermore, a stock with a large P/E ratio should not be an instant deterrent to purchasing the stock. You should not base your investment decisions solely on the P/E ratio, but in conjunction with other investment metrics and information.

Always consider the Price to Earnings ratio when looking at potential investments. The P/E ratio tells you things about a stock that the nominal price on it’s own, cannot. It is important to utilize a variety of different metrics into your investment decisions to help you verify and validate your investment decisions.