In our prior post (The P/E Ratio Explained Part I) we discussed the various methods of calculating the P/E ratio. However, what does it mean conceptually? Essentially, the P/E should tell you how expensive a stock is based on the earnings of the company.
An Example
Let’s say you are presented with 2 choices. You have 2 friends that have businesses making running shoes. They have both been in business about 5 years, and both businesses make $1,000 in profit per year (ok, so they are really small businesses). In addition, both businesses are offering to sell shares of the business to their friends. Friend A is selling 200 shares for $10 a share, and Friend B is selling 500 shares for $5 a share. Which is really a better deal? Let’s keep it basic and not consider the concept of present value for now.
Friend A is selling 200 shares, so let’s figure his earnings per share (EPS). We do this by simply dividing earnings (this is the profit of $1,000 per year) by 200 shares = $1,000 / 200 = $5 per share. So, the P/E is:
P/E = $10 per share / $5 per share = 2.0
How about friend B? We do the same thing - Friend B is selling 500 shares so the earnings per share (EPS) = $1,000 / 500 = $2 per share and the P/E is:
P/E = $5 per share / $2 per share =2.5
So this tells us (in theory) that Friend A’s offer is slightly better - since investors pay less for a share of stock relative to future earnings.
Tags: pe ratio, price to earnings