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.