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Morningstar.com's Interactive Classroom

Course 303
Price/Earnings Ratio

Introduction

Probably the most popular valuation measure used by investors is the price/earnings ratio, or P/E. Numerically, a P/E is the price of a stock divided by its earnings per share (EPS) during the past four quarters. For example, a $20 stock that has earned $1 per share during the past year has a P/E of 20. You can find a stock's P/E ratio on the Morningstar Stock Report. A P/E measures a stock's valuation--its popularity, if you will--by showing what multiple of earnings investors think a stock is worth. The faster investors think a company will grow, the more they like its stock, and the more they are willing to pay for each dollar of its earnings. America Online AOL boasted a P/E of more than 600 at the end of 1999 because investors expected supercharged growth. Airline stock UAL UAL languished at a P/E of about 12 because of its cloudy prospects. So what's the best way to use P/E in valuing stocks?

How to Use P/E

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.

P/E's Flip Side, Earnings Yield

One useful variant of P/E is earnings yield, or earnings per share divided by stock price, usually expressed as a percentage. Earnings yield is just the inverse of P/E (which is equal to stock price divided by earnings per share), so it moves in the opposite direction of P/E. A high earnings yield indicates a cheap stock while a low earnings yield indicates an expensive one. Many value-oriented mutual fund managers use earnings yield to identify bargain stocks. Expressing the relationship as a percentage, as earnings yield does, is in some ways more illuminating than the traditional P/E. Earnings yield can be used for clear comparisons between companies and even between different asset classes. In fact, many mutual fund managers compare earnings yields with 10- or 30-year Treasury-bond yields to get an idea of how expensive stocks are. Indeed, some academic research indicates that over time earnings yield has been one of the better indicators for judging if the market is over- or undervalued. Although the S&P 500's earnings yield hasn't topped the yield of the 30-year Treasury in years, stocks have still outperformed bonds because investors have been willing to pay ever-higher prices for earnings. The S&P 500's meager 3% earnings yield in 1999 (the inverse of its P/E of 33) reflects how optimistic the market is about its future earnings power. By contrast, a stock with a high earnings yield signals that the market currently expects little from it.

Quiz 303
There is only one correct answer to each question.

1 If a company has earned $2 per share and its share price is $30, its P/E is:
a. 30.
b. 6.67.
c. 15.
2 A high P/E generally means:
a. The company has a high book value.
b. Investors expect the company to grow fast.
c. Investors expect the company's earnings to decline.
3 Which of the following is <em>not</em> a good way to judge a stock's P/E?
a. Compare it with Microsoft.
b. Compare it with other stocks in its industry.
c. Compare it with an appropriate benchmark.
4 What effect would a one-time big restructuring charge likely have on a company's P/E?
a. It would have no effect.
b. It would cause the P/E to go down.
c. It would cause the P/E to go up.
5 If a company's P/E is 25, its earnings yield is:
a. 4%.
b. 2.5%.
c. 25 times the company's dividend yield.
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