Investing Basics; P/E

How many times have you looked at the newspaper or on a financial website and wondered why the company cared about the physical education of a stock?  Well, if you don’t know what P/E stands for, that may be one of your thoughts.  P/E is the Price to Earnings ratio of a stock.  For years, it has been one of the indicators used by analysts in making stock selections.

Price to Earnings Ratio means that an analyst takes the currently trading price of a stock per share (or perhaps a recent average), and divides that by the earnings per share.  The earnings may be projected forward earnings, past earnings, or a combination of the two, although it should technically be the last four quarters’ earnings.  This can have different meanings depending on a few factors. 

*   What type of company is it?  I.e.:  A growth company may be putting all their money back into the company and not show many earnings, but still be successful, whereas a value stock may have an ‘attractive P/E’, yet not appreciate much until the market increases. 

*    Which earnings did they use?  Past, or future? 

• Is it a cyclical business?  Is it seasonal, or longer term cyclical?
• Is this a new company or is it one on the way out?

 

Common sense would tell us that the lower the price per share/ how much the stock made per share (or earnings), the better an investment it is.  However, all, and more, of the factors mentioned above can throw that off.  The average P/E over the last century is around 15, meaning a stock trading for about $30/share earned about $2/share over the past year.  That is a benchmark, or indicator tool for you to use in looking at other P/Es.  Wouldn’t it be great to only have to pay $10 per share for a stock that earns $2/share and end up with a P/E of 5?  Well, if the $2 earnings were going to continue, I would think it would be.  These kind of stock market finds may be more difficult to ascertain now, in the computer age, when companies have processors continuously looking for such items.  But, be careful, it could be a company almost on the edge of bankruptcy, or with an obsolete product.  So, use the P/E as a clue, but remember to keep digging!

            Sometimes rather than a number following P/E, you may see the following; N/A.  Not Applicable (N/A) can be used when a stock has had negative earnings or, no profit.  You may also see an incredibly high number, such as 165, and think that perhaps you misread the column, because you know this is a successful company, constantly inventing new devices and changing the way many of us listen to music, use computers, etc.  In this case, you would look at what that company has done historically.  This is an example of a growth company, one that puts its gains back into the bottom line by investing in research and development. 

            Next time you look through the financial section of the newspaper, see if you can find some common companies and compare their P/Es.  You may be surprised what insight you gain.