Price-Earnings Ratio
The price-earnings ratio , or PE (also known as PE ratio), is one of those topics that we have to discuss, not because it is so important to Teenvestors, but because a lot of other investors focus on it. The PE is one way investors use to determine how much a stock costs compared with how much the company earns. The PE is today's price of the stock divided by the amount of money per share made by the company over the past year. Mathematically, it is calculated as follows:
PE = Today's Price Per Share/EPS
Like most of the data in this chapter, PE can be found in a number of good financial websites. The way to interpret PE is that it tells you how many years it will take for you to get back your investment if you buy one share of a company's stock (and all of the company's net profit each year gets distributed as dividends). By way of example, suppose you buy a share of Teenvestor Inc. at $30 and the yearly EPS (earnings per share) is $2. This means that the first year after buying the stock, you would earn $2. You'd earn another $2 for the second year; and another $2 for the third year. If we keep going, you will see that it will take 15 years to earn back a total of $30-your initial investment. You could have figured out how long it will take to earn back the $30 investment by dividing the stock price by the earnings per share ($30/$2 = 15).
Investors refer to stock as either cheap or expensive based on PE levels. For a given stock, a PE of, say, 20 is more expensive than a PE of 15. Some investors believe that, over a long period of time, the PE of companies stays stable, so they watch PEs to see when it is cheap for them to buy the stock. For example, if the PE ratio of Teenvestor Incorporated has been 50 for the past 10 years, and is suddenly 30, these types of investors will buy more of Teenvestor Incorporated's stock in hopes that the PE ratio will move back up to 50, meaning that the stock price may go back up. But one major flaw of focusing on PE ratios is that PE can increase even if the stock price does not go up. If EPS goes down, the PE ratio can go up. What this means is that if you buy Teenvestor Incorporated's stock when it has a PE ratio of 30, and it later goes to a PE ratio of 50, it would not necessarily mean that the company's stock price went up. It could mean that earnings per share went down.
Growth stocks (or companies whose earnings grow by 10-20% per year for about 5 years or more) usually have high PE ratios. PE ratios are typically high for technology and Internet companies if they make money at all. For example, at the height of the Internet boom in 2000, the PE ratio for eBay, the online auction house, was over 2300. This high level of PE is not really meaningful to an investor since the only reason it was so big was because eBay was making very little money at that time. In other words, eBay's tiny earnings at that time, which is used in the denominator of the PE formula (Price Per Share/Earnings Per Share) made the ratio very big. To drive the point home, what will be the PE ratio of a company that has no earnings? Mathematically, when you divide any stock price by 0 (which represents no earnings), you will get an infinite number. Of course, an infinite PE ratio is meaningless. For new industries (such as the industries created from the Internet), you can't use the PE ratio as a measure of whether companies are cheap or expensive until these companies have steady earnings over a 3 to 5-year period. And even then, using PE ratio to spot bargains is flawed.
The latest available PE ratios at the time of this writing for Microsoft Corporation, PepsiCo, and Motorola, were approximately 49.5, 25.8, and 66.4, respectively.
The price-earnings ratio , or PE (also known as PE ratio), is one of those topics that we have to discuss, not because it is so important to Teenvestors, but because a lot of other investors focus on it. The PE is one way investors use to determine how much a stock costs compared with how much the company earns. The PE is today's price of the stock divided by the amount of money per share made by the company over the past year. Mathematically, it is calculated as follows:
PE = Today's Price Per Share/EPS
Like most of the data in this chapter, PE can be found in a number of good financial websites. The way to interpret PE is that it tells you how many years it will take for you to get back your investment if you buy one share of a company's stock (and all of the company's net profit each year gets distributed as dividends). By way of example, suppose you buy a share of Teenvestor Inc. at $30 and the yearly EPS (earnings per share) is $2. This means that the first year after buying the stock, you would earn $2. You'd earn another $2 for the second year; and another $2 for the third year. If we keep going, you will see that it will take 15 years to earn back a total of $30-your initial investment. You could have figured out how long it will take to earn back the $30 investment by dividing the stock price by the earnings per share ($30/$2 = 15).
Investors refer to stock as either cheap or expensive based on PE levels. For a given stock, a PE of, say, 20 is more expensive than a PE of 15. Some investors believe that, over a long period of time, the PE of companies stays stable, so they watch PEs to see when it is cheap for them to buy the stock. For example, if the PE ratio of Teenvestor Incorporated has been 50 for the past 10 years, and is suddenly 30, these types of investors will buy more of Teenvestor Incorporated's stock in hopes that the PE ratio will move back up to 50, meaning that the stock price may go back up. But one major flaw of focusing on PE ratios is that PE can increase even if the stock price does not go up. If EPS goes down, the PE ratio can go up. What this means is that if you buy Teenvestor Incorporated's stock when it has a PE ratio of 30, and it later goes to a PE ratio of 50, it would not necessarily mean that the company's stock price went up. It could mean that earnings per share went down.
Growth stocks (or companies whose earnings grow by 10-20% per year for about 5 years or more) usually have high PE ratios. PE ratios are typically high for technology and Internet companies if they make money at all. For example, at the height of the Internet boom in 2000, the PE ratio for eBay, the online auction house, was over 2300. This high level of PE is not really meaningful to an investor since the only reason it was so big was because eBay was making very little money at that time. In other words, eBay's tiny earnings at that time, which is used in the denominator of the PE formula (Price Per Share/Earnings Per Share) made the ratio very big. To drive the point home, what will be the PE ratio of a company that has no earnings? Mathematically, when you divide any stock price by 0 (which represents no earnings), you will get an infinite number. Of course, an infinite PE ratio is meaningless. For new industries (such as the industries created from the Internet), you can't use the PE ratio as a measure of whether companies are cheap or expensive until these companies have steady earnings over a 3 to 5-year period. And even then, using PE ratio to spot bargains is flawed.
The latest available PE ratios at the time of this writing for Microsoft Corporation, PepsiCo, and Motorola, were approximately 49.5, 25.8, and 66.4, respectively.
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