Tuesday, February 26, 2008

Getting Started In Stock Market Investing - Price To Earnings Ratio

What is a P/E or Price to Earnings Ratio and how can beginners use it when investing in the stock market?

As a beginner in the stock market, one of the first investing concepts I learned about was the price earnings ratio or simply P/E. This ratio is simply a measure of how many multiples of a company's earnings you are paying for it's shares. This is useful because it provides a standard measure which we can use to compare the value of two or more companies. Using share price alone to compare various stocks is meaningless (I'll explain why a little later) - we need a way of comparing apples with apples. Price earnings ratios provide this mechanism.

All other things being equal, a stock with a lower PE ratio would provide better value than one with a higher PE.

How To Calculate Price Earnings Ratio.

P/E ratios are published in the financial pages of most major newspapers. They are also published online on websites like Yahoo Finance as well as the research areas of most online brokers. However, it can still be useful to know how to calculate it yourself. If nothing else, know how it's derived will help you to understand how to apply it to your investing activities.

The price to earnings formula is as follows:

Price To Earnings Ratio = Company Share Price / Earnings Per Share

The Company Share Price is the price that a company's stock is currently trading at. The simplest way to work out Earnings Per Share is to take a company's total earnings and divide by the number of shares on issue (technically you should make some adjustments to this depending on the company's capital structure, but I'll discuss this more in another article).

So if a company's stock is trading at $50 and it's earning $2 per share, then the price to earnings ratio for that company is 25 (50/2).

What Is A Good Price To Earnings Ratio?

As I said at the outset, one of the benefits of using P/E's to value companies in the stock market is that it enables us to compare apples with apples. If we take the example of two companies each trading at $40 per share. Using this information alone, can we determine if one is better value than another? No. The price is the same, but what do we get for that price? Now what if we take these same two entities and say that Company A has earnings of $2 per share while Company B has earnings of $4 per share. Not we can see that for the same price, we'd get twice as much earning power if we were to buy company B. The price earnings ratios would be 20 (40/2) and 10 (40/4) respectively. By comparing the PE's we can confirm that Company B with a PE of 10 is much better value than Company A with a PE of 20.

But what is a good price to earnings ratio? Well there is no simple answer to this. Some value investors advocate using a P/E of 10 as a benchmark. Others say that a P/E ratio of 25 is as high as they'd go. They are a number of way to use a price earnings ratio when investing in the stock market.

I think that it's best used in comparative analysis. Use it when comparing a group of companies. If you extend the example above from just 2 companies to an entire industry sub-group, you will quickly see where the value lies.

Another way to use the price to earnings ratio is to turn it upside down. This then becomes the earnings yield (earnings divided by price). To convert an existing P/E ratio into an earnings yield use the following formula:

Earnings Yield = 1 / Price To Earnings Ratio

So continuing on from the example above, a PE of 20 would give an earnings yield of 5% (1/20) while a PE of 10 would yield 10% (1/10). Now we can take this figure and compare it to returns from other investments. A useful benchmark is the long term Government Bond yield. If you can get a risk free return of say 7% from a government bond, this gives you a good benchmark with which to compare your earnings yield. I'll write more about earnings yields in an upcoming article.

What Are The Limitations Of P/E Ratios?

I must now stress that although this ratio is very useful, it must not be used in isolation. It should be used in conjunction with other measures of value, financial performance and stability. Apply it as a filter to create a short list of investment opportunities. I said at the start of this article that all things being equal, a company with a lower PE provides better value. While this is true, just remember that things are never equal. That's why you need to look at other things like debt levels and the ability to service debt, return on equity, return on assets and so on.

But as a beginner in the investing game, the price to earnings ratio is a good why to start exploring value in the stock market.


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Beginner Stock Trading said...

Thanks for the information.


I would like to share with investors a measurement of valuing a stock that I would consider the very most important factor in determining whether a stock is a tremendous bargain or not.

This could be the biggest factor of all in determining if you will make huge amounts of money investing in stocks or not.

I find that the best indication of how undervalued a stock is is the price to sales ratio or what is commonly referred to as market cap.

Simply stated. If a company does 1 billion in annual sales but it has a market cap of 100 million dollars than the price to sales ratio is ten to one. In other words the market is valuing a company that does 1 billion dollars in annual sales at just 100 million dollars. But what does this mean. It means everything if you are a classic value investor.

Here is a perfect example of why the price to sales ratio is so very important if you are a value investor in stocks. If our 1 billion dollar company is breaking even that is they are not making a profit nor losing money. Lets say the company has 250 millon dollars in long term debt and 80 million dollars in cash. We will say they are in the food business they make a wide aray of food products. Maybe the company did a buyout of another company a few years ago that did not work out as well as expected. So thats why the company is having trouble making a profit but things now seem to be moving in the right direction. If I purchase shares in the company for say 10 dollars. And over a five year period the company improves their earnings performance to the point where their now earning say 60 million dollars on sales of one billion two hundred million dollars. Thats a profit margain of 5%. If the stock were to now trade at twenty times earnings that would now mean that the price of the stock would be at 120 dollars a share or another way to put it the marketcap is now one billion two hundred million instead of 100 million.

The problem for me is not that this investment method is not effective it works great. I purchased seaboard stock back in 2000. I think it was for 190 dollars a share around that. I following the exact method I describe above. I sold my shares about five years later for 2500 dollars yes thats correct 2500 dollars or more than twelve times what I paid for the shares. Seaboard was profitable when I bought it and profitable when I sold it. The stock was just a great undervalued stock that was overlooked by investors.

Like I was saying before the problem is not with this investment method. Its that stocks like seaboard are very rare indeed theirs just not a whole lot of quality companies out their selling a very low price to sales ratios. Another issue that I have been having is when a company of decent quality trades at a very low price to sales ratio its not long before a private equity firm or the family of a family owned company takes notice and usually makes a low bid for the shares and takes the company private preventing me from realizing the enormous gains that mght have been possible had I not been forced to sell my shares out to a party that was making a very unfairly low offer for the shares of the company.

Another thing to keep in mind when it comes to value stocks that have a low price to sales ratio that could give the buyer a tremendous advantage is this.

I mentioned earlier that are food company had 80 million dollars of cash on their balance sheet now if the company choose to they could buy back a large chunk of their stock maybe 30 million dollars worth of the shares outstanding it would only cost them 30 million dollars they still would have 50 million dollars of cash left on their balance sheet. This means that under the positive earnings outlook for the company the stock price could even be much higher than 120 dollars a share. If the company were to retire a large percentage of their exsisting shares in a stock buyback.


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