|Course 402: Using Ratios and Multiples|
P/E is the most popular valuation ratio used by investors. It is equal to a stock's market price divided by the earnings per share for the most recent four quarters. The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales. Moreover, earnings per share results and estimates about the future are easily available from just about any financial data source imaginable.
P/E = (Stock Price) / EPS
The P/E ratio measures how much investors are willing to pay for a company's earnings. Generally speaking, the higher the P/E ratio, the more investors are willing to pay for a dollar's worth of a company's earnings. Stocks with high P/Es (typically those with a P/E exceeding 30) usually have greater future growth prospects, while stocks with low P/Es (typically those with a P/E below 15) tend to have lesser future growth prospects. However, a P/E ratio by itself does not say much about a stock's valuation.
The most useful way to use a P/E ratio is to compare it with a certain benchmark. Good benchmarks are the P/E of another company in the same industry, the P/E of the entire market, or the same company's P/E at a different point in time. Each of these approaches has some value, as long as you know the limitations.
For example, a company that is trading at a lower P/E than its industry peers could be a good value, but even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the P/E ratio. All else equal, a firm that has better growth prospects, lower risk, and lower capital reinvestment needs should be rewarded with a higher P/E ratio.
You can also compare a stock's P/E with the average P/E of the entire market. However, the same limitations of industry comparisons apply to this process as well. The stock you are investigating might be growing faster (or slower) than the average stock, or it might be riskier (or less risky). In general, comparing a company's P/E with those of industry peers or with the market has some value, but you should not rely on these approaches to make final buy or sell decisions.
Comparing a stock's current P/E with its historical P/E ratios can also be of value. This is especially true for stable firms that have not undergone major business shifts. If you find a solid company that is growing at roughly the same rate with roughly the same business prospects as in the past, but is trading at a lower P/E than its long-term average, you should start getting interested. It's entirely possible that the company's risk level or business outlook has changed, in which case a lower P/E is warranted, but it's also possible that the market is simply pricing the shares at an irrationally low level.
Next: Price/Earnings: The Drawbacks >>
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