Course 303: Price/Earnings Ratio
How to Use P/E
In this course
1 Introduction
2 How to Use P/E
3 P/E's Flip Side, Earnings Yield

First, you can compare a company's P/E with the P/Es of similar companies and see how it stacks up. Bear in mind, however, that there may be good reasons why the company you're looking at is cheaper or more expensive than its peers. Microsoft MSFT, for example, sports a premium P/E relative to other software companies because of its dominant market position. Also, it could be the case that the entire industry is over- or undervalued, in which case the benchmark you're using isn't really a good measure. (For example, saying that an Internet stock is cheap relative to other Internet companies isn't really a ringing endorsement, since the entire industry has been overblown in recent years.) The same caveats apply to comparing a company's current P/E with its historical valuations. Make sure that the company hasn't undergone fundamental changes, like selling off a division or buying a competitor, that would make historical comparisons less meaningful. Another way of using P/E is to compare a company with the average P/E of the S&P 500 or some other benchmark. Although this type of comparison can offer a lot of insight into how a company is valued relative to a broader group of companies, make sure that you compare apples to apples. If you're looking at the P/E of a small-cap stock, for example, measure it against a small-stock benchmark such as the Russell 2000 index rather than the S&P 500, which is comprised of larger stocks. Another tricky thing about P/Es is that the "E" part of the ratio can be slippery. A bad year for a company can take a big chunk out of earnings and thus jack up the P/E tremendously. For example, the P/E of temp company Olsten OLS, was a whopping 40 because of a big one-time charge (for restructuring) in the second quarter of 1998. Without the charge, Olsten's P/E would have been 11, below the average for its sector.

Next: P/E's Flip Side, Earnings Yield >>


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