P/E Ratio has nothing to do with gym class
The stock market made a mild comeback last week but has a long way to go to undo the mess that has splattered across our economy over the past year. Many people have been wary of putting money back in the market, but any time there is a short burst of positive gains, no one wants to miss the boat.
One basic statistic you always hear on CNBC or any other financial news outlet is P/E Ratio. It’s a simple indicator and a great way to figure out what stocks are “cheap.” P/E Ratio is short for Price-Earnings Ratio and is simply a comparison of the current share price of a stock relative to its earning per share. The formula is:
Stock Price / Earning Per Share (EPS)
Make sure the EPS is a yearly amount. The lower the ratio, the cheaper the stock is perceived. Keep in mind that this is just one of many indicators when determining what stocks to buy, and even the perception of P/E Ratios fluctuate among sectors (tech companies tend to have higher P/E Ratios because of their potential to accumulate earnings exponentially faster than well-established companies like McDonald’s, Coca-Cola, etc.), so don’t just find yourself a low number and start trading like Gordon Gecko.
Instead, understand what it means and use P/E Ratio as a starting point in learning more about public companies. Another useful tool is estimated P/E, which is the same calculation except the earnings used are the estimated earnings. This is often times a better measure. Suppose a current P/E Ratio is 10 (assume a $20 stock with EPS of $2/share) but all the analysts know the company has been on hard times since the last earnings announcement and the consensus estimate for the next EPS announcement, scheduled for next week, is $0.50/share. That would put the estimated P/E Ratio at 40 ($20 / $0.50), indicating a much more “expensive” stock. In other words, the earnings appear to be dropping a lot but perhaps the stock price hasn’t caught up to the decline yet.
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