Investing Advice

What is a P/E ratio?

Ask different investors and you’ll probably get different answers.

In the simplest terms, the price-to-earnings ratio is the dollars that you pay for each one-dollar of earnings.

It’s calculated by dividing the price per share, by the past 12 month’s earnings per share. You will get the same answer by dividing the market cap by the company’s total earnings for the past four quarters. When you determine this number, make sure not to accidentally use the earnings from only the last quarterly income statement, or 10-Q, filed with the SEC.

On Jan 31, 2000, the average P/E of the S&P 500 was 25.6, and the Nasdaq 127. These numbers have fallen considerably since then, to about 18 for the S&P and 49 for the Nasdaq. Companies that have lost money in the past four quarters have no P/E ratio.

It is better to use forward estimated earnings for comparison if a company is growing at an accelerated pace, since the past 12 months may be quite different than what is projected for the coming year. But if you choose to use the estimated forward earnings rather than the trailing earnings in your comparisons, you’re working with guesses instead of facts.

If you stop to think about it, even a 20 to 1 ratio is hard to justify. If a company is earning a net 5% on sales, it would take 20 years to earn a full return on your money, even if the company was paying out all earnings as dividends.

In reality, companies use earnings to redeem bonds and repay loans. They pay guaranteed dividends to preferred shareholders and keep a cash reserve to meet the business’s current needs if sales slow. They need funds for research and development, and expansion of the business. Your share of the earnings, the dividend, might not be much after these priorities are met.

“Value” style investors look at the P/E ratio as a major indicator of the fair value of a stock. If the number is lower than the average, they say that it may be a bargain. If the ratio is higher than the average, they say that the stock is probably overpriced.

I agree that if other important factors are weighed along with the P/E ratio, a healthy company in a growing industry with a low ratio is definitely a bargain. If you limit yourself to “undervalued” companies, you will miss the best stocks.

Most of the biggest winners in the past years have been stocks with HIGH P/E ratios, even before they made their biggest moves upward in price, including Microsoft, McDonald's, Home Depot, and Wal-Mart. AOL had a P/E of 100 in 1994, and then rose 14,900% by Dec 1999.

When placing orders through your on-line broker, create a paper trail of all transactions. If you lose money because a trade was not executed, present copies of your evidence to your broker, asking for swift reimbursement of your loss due to their negligence.

If you don’t obtain satisfaction, arbitration is your next step. Overall, 60% of cases considered by arbitrators go in favor of the customer and against the brokers. If your loss is substantial, consider hiring an attorney.

Make a habit of printing out the information on your web browser screen when you place an order. This may be the only way you can prove that you placed a buy, sell, or limit order at that time.

Other Stock Market Basics Topics:

  1. Stock Market Investing – the Right Way
  2. More Stock Marketing Investing
  3. How to Pick Winning Stocks
  4. The Golden Rule of Investing
  5. Avoid Psychological Traps to Have Successful Investing
  6. Changes in Stock Values Can Be Big Numbers
  7. How to Invest Smart
  8. Stock Advice - Important Selling Rules
  9. Poor Stock Buying Decisions
  10. Market Indicators
  11. Stock Market Cycles
  12. When a bear stock market may not be a bear market
  13. Stock Index Futures
  14. Four Things that Affect Stock Valuation
  15. What is a P/E ratio?
  16. Value Investing
  17. Cheap Stocks
  18. What is a Financial Statement?
  19. Analyzing Financial Statements
  20. Stock Market Tip - Red Flags to Look For When Investing?
  21. The Annual Report – How to Read
  22. Stock Market Analysts – Stock Market Advice and Tips

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