Investing Tip:

Using P/E Ratios

This is an "investing basics" stock tip.

One of the most prevalent measures of stocks are p/e ratios. You see them quoted in almost every newspaper. What are they, and what good are they?

A price/earings (p/e) ratio is a simple ratio of the price of a share of stock, divided by the profit per share. If a company had 1 million shares outstanding, made a $500,000 profit and had a stock priced at $10 the p/e ratio would be 20 (earnings per share would be $500,000/1,000,000 or 50 cents per share, so the p/e is $10/.50 or 20). Why use a ratio and what does it tell us? Ratios are used to give us relative information. How can you compare the profitability of WalMart versus that of Big Lots for example, when one company is 100 times the size of the other? The answer is to use a ratio of profits per share to stock price.

A p/e ratio tells us a number of different things about a company. First it tells us if the company is making money. If the company is losing money, there is no p/e at all. Second, it gives us some sense of how many times one year's earnings people are willing to pay for a stock. In the above example, people have decided that with this company, they will pay 20 times a year's profits for that stock. P/e multiples range from as low as 2 or 3 (very, very rare) to 500 or more. Right now the average stock has a p/e of around 20. It also can tell us about growth expectations. Usually a very high p/e tells us it's a high growth stock. People are willing to pay a high multiple of earnings because they expect future earnings to be even more. It also can be an indicator of an overpriced stock, or of a potential bargain. If the average p/e in an industry is 25, and you find a stock in the same industry with a p/e of 20 it might be a deal, or if it's at 50, maybe the stock is overpriced.

But you must be very careful using a p/e ratio because it's based upon historic earnings. If a company made a lot of money last year, but is projecting a loss for this year, it will have a very low p/e because it's based upon old information.

P/E ratios are used for two reasons. First, because they are easy to calculate they are listed in almost every newspaper making them readily available. Second, because it packs a lot of data in one number. But it's advantage is it's limitation. There is often too much data in that one number. It's like choosing tools. If you just had one tool, you'd probably choose pliers, as they are very versatile. But if you could choose 100 tools you might not use them at all. A p/e is a great number if you just use *one* number. But if you have lots of data available it's just one tool in your toolbox. Remember that *any* number is just a starting point, not the end, of your research.

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Donald Steinmann and Advanced Financial Management assume no responsibility for any actions taken due to comments made in The Investment Tip of The Week.

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"A good decision is based on knowledge and not on numbers."
-- Plato