Price Earnings Ratio

Price Earnings Ratio or Price to Earnings Ratio

Defining Price/Earnings ratio

The price to earnings ratio (P/E) is the relationship that the price of a share with its earnings per share or (EPS). Commonly you will see expressed in trailing twelve month form, the last fiscal year, or in Forward form using analysts forward estimates.

The formula is:

P/E Ratio  =  (Share Price/EPS)

Example: If a share is selling at $100 and is currently earning $5 dollars per share, the P/E ratio for that share is

P/E Ratio = ($10/$5.00) = 20

The P/E Ratio is often used as a measure of value for shares but is a subjective test due to a number factors including:

  • What constitutes a high P/E is subjective. The Average P/E of the S&P 500 has been 16.5 over the last 100+ years. Some stocks may warrant a higher P/E for more growth potential or safety of earnings and some may warrant lower ones for more likelihood of earnings tumbling.
  • A P/E Ratio may not take into effect certain one time charges, or net income may diverge from Owner’s Earnings in some way that make the P/E ratio to be a trick.
  • Another difficulty arises when you valuate a company that has components of different maturity. For example Netflix has a profitable domestic division that is more mature but an immature international business that requires more capital expenditures. Netflix could be wisely investing in growth and it would make its P/E a very bad measure to evaluate the company with.
  • Sometimes a company has a low P/E for a reason and its future prospects are poor
  • High P/E does not mean expensive always. In 2004, both Apple (AAPL) and Google (GOOG) were “expensive” stocks with Price to Earnings ratios above 35. Then they went up 1200% and 600%. The fact that Apple’s share price appreciated from $15 to $347 and Google’s $85 to $538. If a stock grows very rapidly it can justify a P/E. This requires an investor to do a sort of a sanity check to see what the market is expecting.

Since 1946 the S&P is up 7.4% a year and corporate profits are up 7.2% a year. It’s that simple, stocks follow profits. According to (Multpl) the average P/E from 1880 to now of the S&P 500 has been around 16.5.

Be conservative

Many investors these days or analysts focus on Forward P/E instead of Trailing Twelve Months, while Benjamin Graham which preach  the more conservative 5 year average as mentioned in his book, the Intelligent Investor.

Great Companies at a Fair Price, Paying for Growth

An investor should have especially sound logic when purchasing an investment at a Price to Earnings ratio higher then the 16.5 average of the S&P 500. The margin of safety in an investment is cut the larger the Price to Earnings ratio and it means you are more likely to make a mistake. Investors more frequently pay too high a price for future growth then they do pay too low a price.

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” 

-Warren Buffett

Much less frequent is the mistake of the investor who doesn’t purchase the Google or Apple at a ratio above 35 as is the one who purchases the profitless company they don’t understand at a very Price to Earnings ratio and loses money.

InvestCorrectly Learning How to Invest Series
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