Friday, January 30th, 2009
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
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Monday, January 26th, 2009
While the economy hovers in a holding pattern of uncertainty - I think it’s a good idea to get back to basics and really understand some of the fundamentals of stocks. So, let’s start with the metric most investors are familiar with: the P/E ratio.
The P/E Ratio Explained
In a nutshell, the P/E is simply the price of a stock per share divided by earnings per share (also called “EPS”). However, keep in mind that the way the P/E is calculated depends on what period of time you are looking at.
The “Current” P/E
The “current” P/E is the most basic variation of the P/E. It is simply the current market price divided by the most recent annual earnings per share (such as full year 2008 earnings for a company).
The “Trailing” P/E
If you look up a quote for Exxon Mobil on Yahoo Finance, the summary that is returned shows “P/E (ttm)“. This means the current market price is divided by “trailing twelve month” earnings per share. Essentially, you are taking the current stock price and looking backward at earnings for 4 quarters. Since earnings are reported quarterly, in April ‘09 you would divide the current price by earnings per share for Q2 ‘08 through Q2 ‘09 combined. Why? This gives you a more recent earnings benchmark to use for valuation.
The “Forward” P/E
Last but not least is the “forward” P/E - which tends to be the most controversial variation of the metric. Why? Well, because it is essentially using forecasted earnings for the next financial year in the denominator. Investors should consider the calculation of the forward P/E very carefully, as certain assumptions made by the analyst calculating the numbers can greatly affect this number. As a general rule, it is best to be conservative and underestimate earnings rather than overestimate them.
Tags: pe, pe ratio, price to earnings
Posted in Stock Basics, Stock Metrics | No Comments »
