Making sense of a companies’ P/E ratios is easier than you think

financeJeremy Siegel, Ph.D, wrote over on Yahoo finance yesterday “What’s the Stock Market Worth Now?” In the article, he takes a look at a well known financial ratio, the P/E (P-E) or Price to Earnings ratio. He surmises that their is still great upside potential to the market as P/E ratios are historically low.  He also does a fairly good job explaining the difference between operating earnings and GAAP reported earnings and explains which number is more meaningful to look at ( I won’t get into this discussion as the difference in the two numbers on average is minimal). As mentioned, he looks at how current P-E levels relate to historical levels and provides insight as to what he thinks this will mean to the markets in the short and long term. Below, I will do my best job to explain what P/E ratios should mean to you and provide an example of how to evaluate them.

First, let’s discuss P-E ratios. It’s really quite simple, this ratio looks at the price of the stock compared to how much they’re earning. What does this tell you? By itself, very little. But if you compare a P-E of one company to it’s peers and or the industry and to historical levels, you can get a better idea if the stock price is over or under valued and how much people are paying for the earnings.

“Over the past century, stocks have been valued, on average, at about 15 times annual earnings, a number called the price-earnings ratio, or P-E ratio. This implies that annual earnings on stocks have averaged 1/15, or 6.7 percent of the stock’s price. Another way of looking at this is that the average dollar invested in the stock market has earned 6.7 percent, which is called the earnings yield and is the reciprocal of the P-E ratio. Since earnings derive from real assets (factories, inventories, copyrights, etc.), the earnings yield represents the average real return to stock investors. This is why lower P-E ratios imply higher earnings yields and better returns for investors.”

The Price to Earnings (P/E) Ratio is an indicator of a company’s expected growth in earnings.  The P/E Ratio is calculated by dividing the most recent close price of a stock by its most recent reported Earnings Per Share (EPS) value. There are many different variations of the P/E calculation though – some use projected earnings to calculate a “forward” looking price to earnings, while others may use a trailing or past average of earnings to calculate the P/E ratio.

Investopedia explains Price-Earnings Ratio – P/E Ratio
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn’t tell us the whole story by itself. It’s usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company’s own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the “multiple”, because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of  current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

Let’s evaluate Wal-mart and its competitors for an example.

pe ratios

In the above example, the p/e ratio looks at the price of the stock compared to its previous 12 months of earnings reports averaged.

So, people purchasing Wal-Mart stock are willing to pay about $15.81 per $1 of earnings. Compare that to Amazon, where people are paying $78.41 per $1 of earnings. What does this tell you? What’s the better buy according to their P/E ratios?

At first glance, you may be inclined to think that Wal-Mart is the much better deal. Heck, it costs nearly $60 less to earn the same $1. So why is Amazon so high? That’s the problem with using only one ratio – it doesn’t tell the entire picture. The truth is, speculation on future earnings of Amazon is showing that people expect their earnings to increase in the future, while Walmart may not be slated to grow as fast. So, it’s important to consider future earning potential when evaluating the current p/e ratio of a particular company or industry. After weighing the future predicted earnings against the past, you can determine which stock is the better value. Do you want to go with a potentially less risky/less rewarding stable stock such as Walmart – or with a stock such as Amazon that may be priced a bit high – but has the potential to really do well. This is a question only you can answer.

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