P/E Ratio

price/earnings ratio, price-earnings multiple, or simply, the multiple.It is simply the ratio between the price and earnings per share of a company.

P/E ratio is a useful measure of whether any stock is overpriced, fairly priced, or underpriced relative to a company’s money making potential. It’s obtained by dividing the current price of the stock by the earnings for prior 12 months or fiscal year.

The P/E ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investments- assuming, of course, that the company’s earnings stay constant. So P/E value 10 says that it will take 10 years to earn your original investment.

The fact that some stocks have P/E’s of 40 and others have P/E’s of 3 tells you that investors are willing to take substantial gambles on the improved future earnings of some companies, while they’re quite skeptical about the future of others. You will be amazed to see the range of P/E values.

You’ll find that the P/E levels tend to be lowest for the slow growers and highest for the fast growers, with the cyclicals vacillating in between. We shouldn’t be comparing based on P/E value as it makes no sense to compare apples to oranges.

Sometimes you’ll hear that “this company is selling at a discount to the industry” – meaning that its P/E is at a bargain level. Before you buy a stock, you might want to track its P/E ratio back through several years to get a sense of its normal levels. ( New companies, of course, haven’t been around long enough to have such records.) With few exceptions, an extremely high P/E ratio is a handicap to a stock, in same way that extra weight in the saddle is a handicap to a racehorse. A company with a high P/E must have incredible earnings growth to justify the high price that’s been put on stock. It’s a miracle for even a small company to expand enough to justify a P/E of 64.

Company P/E ratios do not exist in a vacuum. The stock market as a whole has its own collective P/E ratio, which is a good indicator of whether the market at large is overvalued or undervalued. If you find that a few stocks are selling at a inflated prices relative to earnings, it’s likely that most stocks are selling at inflated prices relative to earnings.

Interest rates have a large effect on the prevailing P/E ratios, since investor pay more for stocks when interest rates are low and bonds are less attractive. But interest rates aside, the incredible optimism that develops in bull market can drive P/E ratios to ridiculous levels.

The P/E ratio of any company that’s fairly priced will equal its growth rate( growth rate of earnings).

If the P/E of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a good bargain. A company, say, with a growth rate of 12 percent a year and a P/E ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown. In general, a P/E ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative. If your broker can’t give you a company’s growth rate, you can figure out for yourself by taking the annual earnings from value line or S&P report and calculating the percent increase in earnings from one year to next. That way, you’ll end up with another measure of whether a stock is or is not too pricey.