Course 108: Learn the Lingo--Basic Ratios
Price/Earnings and Related Ratios
In this course
1 Introduction
2 Earnings Per Share
3 Market Capitalization
4 Profit Margins
5 Price/Earnings and Related Ratios
6 Price/Sales Ratio
7 Price/Book Ratio
8 Price/Cash Flow
9 Dividend Yield
10 The Bottom Line

One of the most popular valuation measures is the price/earnings ratio, or P/E. The P/E is the price of a stock divided by its EPS from the trailing four quarters. As an example, a stock trading for $15 per share with earnings of $1 per share during the past year has a P/E of 15.

P/E = (Stock Price) / EPS =

The P/E ratio gives a rough idea of the price investors are paying for a stock relative to its underlying earnings. It is a quick and dirty way to gauge how cheap or expensive a stock may be. Generally, the higher the P/E ratio, the more investors are willing to pay for a dollar's worth of earnings from a company. High P/E stocks (typically those with a P/E above 30) tend to have higher growth rates and/or the expectation of a profit turnaround. Meanwhile, low P/E stocks (typically those with a P/E below 15) tend to have slower growth and/or lesser future prospects.

The P/E ratio can also be useful when compared with the P/Es of similar
companies to see how the competitors stack up. In addition, you can compare a company's P/E with the average P/E of the S&P 500 or some other benchmark index to get a rough idea of how richly a stock is valued relative to the broader market.

One useful variant of P/E is earnings yield, or EPS divided by the stock price. Earnings yield is the inverse of P/E, so a high earnings yield indicates a relatively inexpensive stock while a low earnings yield indicates a more expensive one. It can be useful to compare earnings yields with 10- or 30-year Treasury bond yields to get an idea of how expensive a stock is.

Earnings Yield = 1 / (P/E ratio) = EPS / (Stock Price)

Another useful variant of P/E is the PEG ratio. A high P/E generally means that the market expects the company to grow its profits rapidly in the future, so a much greater percentage of the company's potential earnings are in the future. This means its market value (which reflects those future earnings) is large relative to its present-day earnings.

The PEG ratio can help you determine if a stock's P/E has gotten too high in these cases by giving you an idea of how much investors are paying for a company's growth. A stock's PEG ratio is its forward P/E divided by its expected earnings growth over the next five years as predicted by a consensus of Wall Street estimates. For example, if a company has a forward P/E of 20 with annual earnings estimated to grow 10% per year on average, its peg ratio is 2.0. Again, the higher the peg ratio, the more relatively expensive a stock is.

PEG = (Forward P/E Ratio) / (5-Year EPS Growth Rate)

As with other measures, the PEG ratio should be used with caution. PEG relies on two different Wall Street analyst estimates--next year's earnings and five-year earnings growth--and thus is doubly subject to the possibility of overly optimistic or pessimistic analysts. It also breaks down at the extremes of zero-growth or hyper-growth companies.

Next: Price/Sales Ratio >>

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