I’m a big believer in knowing a little about the market before you jump in, even if you are using a broker or relying on your 401k plan to get you through your golden years. I am not speaking about becoming a financial whiz kid, I am just speaking about knowing the very basics so that you won’t get swindled when dealing with your personal finances. Today I thought I would start off with a term that you hear all the time when people are discussing a companies value. This term is P\E Ratio.
The P\E Ratio simply means Price to Earnings Ratio. Okay what’s that mean? That means that you take the current price of what a stock is trading at and then you divide it by the EPS. Okay what’s an EPS? EPS simply means Earnings Per Share. The earnings per share of a stock is how much of a companies profit is placed on a single share of stock. I will go more in detail of EPS in another tutorial but for right now let’s stick with the P\E Ratio stuff. So as I was saying before you simply divide the price of a stock by it’s EPS. Let’s give an example.
We have Company A and it’s stock price is at $25 a share. Now we go look up Company A on finance.google.com and we find out that the EPS is at $1.25. Now we take the price of the stock and divide it by $1.25. It would look like this 25/1.25 = 20. So we have found out that our P\E Ratio is 20. Most investors look for high P\E Ratios as part of the formula to determine if a stock is a good buy or not. A multiple of 20 depending on industry is definitely a stock that you wuold want to take a look at.
The last question you are probably asking yourself now that you know what the P\E Ratio is and how to calculate it is, “Why is it important?”. A P\E ratio is important because it usually indicates how much earnings a company is expecting to make in its future. An investor that is looking at a stock’s P\E that is 20 is willing to pay $20 for every $1 of a companies current earnings. That is because he is expecting that company to grow. There is one word of caution though, when looking at a stock to purchase use the P\E Ratio only as a comparison indicator not the whole story. You want to check a companies pass P\E and also it’s rivals in the same industry P\E. That will give you a better picture of the stocks future earnings.