making your money work for you, instead of you working for it.

Understanding the Importance of the Price/Earnings (P/E) Ratio

People who own stock in a company (public or private) want to know one thing above all else: Which way is the share price headed? Without reaching for the crystal ball, there is a financial ratio that can give you some clues on whether shares are cheap or expensive.

The Price/Earnings ratio (P/E) is the unit pricing method for stocks. Ever start to buy a big can of tuna (Ok, I really love tuna) thinking you would get the best deal only to find that the price per ounce (let’s call it the “P/O”) was about twice as high as the P/O of the little six-ounce can? Unit pricing has made grocery stores safe for those of us who can’t do long division in our heads, and the P/E lets us compare stock prices in the same way. To compute it, you divide the price per share by the company’s earnings per share (EPS). The P/E is the price of a dollar of earnings (profits). For example, if you buy shares of a stock that has a P/E of 30, you pay $30 for each $1 of profit.

What you are really buying when you buy a share of stock is the right to a portion of a company’s future profits. But since a “share” of a company is not defined (it could represent one-half ownership of a company, or one-five-billionth ownership, or anything in between), the price per share is meaningless. The P/E converts price per share into the cost of a dollar’s worth of annual profits. That’s a much more meaningful number.

For example, let’s imagine two similar companies, one selling for $100 per share and one for $50 per share. Would the $50 company be a better buy? (If you said you don’t know, you’re with me so far. If you thought “yes,” reread the previous paragraph.) But let’s suppose that the $100 company is earning $5 per share and the $50 company is earning $2 per share. That would give the $100 company a P/E of 20 and the $50 company a P/E of 25. Now which is the better deal (investment)?

If you said you still didn’t know, you’re right. The $100 company is cheaper in terms of current earnings, but what really counts is how much the company will earn while you own it. That potential is much harder to measure, but understanding P/E is the first step in estimating a company’s true value.

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