Grasp the Price to Earnings Ratio
This newsletter is intended to help investors understand the price to earnings ratio. A question was posed by a CFE Finances customer; who asked if a P/E ratio of 1 is the best P/E ratio. It is a great question so lets dive in. When the P/E ratio is 1, it indicates the stock is out of favor (possibly undervalued). It also means the company has excellent earnings and has good value. For example if the price of a stock is $10 and company’s earnings per share is $10 the P/E ratio is 1. Like we indicated, a $10 earnings per share is very good. But a price of $10 is low for a stock that has such great earnings. On the other hand when a stock has such a low P/E ratio it can mean investors are not buying the stock. But I have to mention the example we just gave doesn’t happen. The reason it doesn’t happen is a company with $10 in earnings per share, their stock price would be much higher because they are making so much money. We calculate earnings per share (E.P.S.) by dividing the net earnings into the number of shares a company has to sell called outstanding shares. The way the ratio works is you need the stock price to appreciate along with the company earnings to give you a P/E ratio that is comparable to other stocks within its sector or industry. Investors need to like the stock and buy it for this to happen.
Also think of the P/E ratio as a fundamental ratio, as a P/E ratio increases it shows us as an investor the stock is price is appreciating due to having strong sales and earnings. Another way to think of the P/E ratio is when it is high the stock is in favor due to the emotional effect buyers have for the stock. When a company doesn’t have a P/E ratio it due to having no earnings. In other words buyers like or sometimes love a stock so much they do not pay attention to the P/E ratio. Some investors buy a stock due to their strong sales of company products or services and believe the company will be profitable in the future. You may ask how does a company operate their business with no earnings. Companies use their stock equity to grow their business as well as supplying cash flow to run their business. Another tip for another time, this is called market capitalization.
Not to confuse you but you can also view the P/E ratio as what you as the investor pays for each dollar a company earns. For example if a P/E ratio is 10 you can think you are paying $10 dollars for each dollar the company earns. So if the P/E is too high, we say a stock is expensive.
Remember before buying or selling a stock we need to compare companies in its sector or industry. For example when researching Home Depot stock we want to compare it to Lowes stock. We need to determine both Home Depot (HD) and Lowes (LOW) 5-year average P/E and present P/E. A stock P/E ratio can be calculated or can be found on a Value line survey. We want to buy a stock when its P/E ratio is below the 5-year average and sell it when P/E ratio becomes too high. A good rule of thumb is sell a stock when the P/E ratio is 1.25 times the P/E ratio when the stock was purchased.
Good luck and happy investing from CFE finances! We will be in touch with another newsletter soon. If you have any questions or concerns email us from our contact page.