Tuesday, December 15, 2009

Predicting the Future: The Price to Earnings Ratio

Wall Street

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What is the P/E Ratio?

The P/E is a mathematical ratio. The result will not be a dollar amount, but a mathematical ratio: the relationship between the stock price and the company’s earnings. The company earnings is given by the EPS or the “Earnings per share” of the common stock. You compute the P/E by taking the share price and dividing it by the company’s EPS. P/E = Stock Price / EPS

To illustrate, a company with a share price of $40 and an EPS of 8 would have a P/E of 5 ($40 / 8 = 5). As you can see the result is the ratio ‘5.’ In the Wall Street jargon, the ratio is referred to as ‘multiples.’

How to interpret the P/E ratio or multiples

What does the ratio ‘5’ tell you? The P/E ratio of 5 tells us what the market is willing to pay for the company’s earnings. The higher the P/E the more investors are willing to pay for the company’s earnings. But there’s room for disagreement here. While some investors read a high P/E as an overpriced stock, others may see it as an indication that the market has high hopes for this stock’s future and has bid up the price. Now, a low P/E may be taken as weak signal of attractiveness by the market. It might also mean this is “a sleeper” waiting for someone to shake it out of its slumber and take off running. Known as low value stocks, many investors make it a point of “discovering” these potential marathoners.

So what is the “right” P/E?
Don’t let anyone tell you what the ideal or right P/E ratio is or might be. No such a talisman. It all boils down to the investors’ desire to pay for earnings.

However, investors do not go blindly into the fray. They have one more tool: the market’s P/E ratio average. The P/E ratio for the entire market is approximately ’20.’ All it means is that on average all investors were willing to buy stocks of companies whose earnings make sense: that neither undervalued nor overvalued. Just be aware that these multiples fluctuate from time to time.

If a company’s P/E is 18, I would feel comfortable with it. Likewise, if the multiples show 22 or 23, there’s no reason to lose sleep over these multiples. Why not? Well, because the multiples are hovering around the market’s average which is 20. If you compare our ‘5’ ratio to the market’s, we can draw some conclusions: (1) the stock is undervalued (2) the stock may be a sleeper (3) the stock is a dud and may never move; especially if the company is in an ‘old economy,’ type of business. Hm, maybe it is time to look for a higher multiples stock.

During the Dot.com bubble, many stocks reached the incredible multiples of 140, 160, some even 400. In hindsight, would you buy stocks whose multiples are in the hundreds knowing that the market’s average is 20? Probably not—that is till the next bubble.

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