P/E Ratio......Wat is it?

A Look at P/E Ratios
by Roger Wohlner

Price/earnings (P/E) ratios are a common measure of stock value, both
for individual stocks and the overall market. Calculating a P/E ratio is
straightforward - it is simply the price of a single share of stock
divided by the company's per share earnings.

For example, a stock selling
at $50 per share with $2 per share of earnings would have a P/E ratio
of 25. However, P/E ratios can be calculated using different earnings
numbers. Trailing P/E ratios, which are typically reported in
newspapers, use earnings per share for the most recent four quarters, while
forward P/E ratios use forecasts of future earnings per share.

To understand what a P/E ratio represents, consider what it means in
terms of how much you would pay for a business you want to purchase. The
value of that business would be largely determined by how much income
it generates and how long it would take to recover the purchase price
with that income. You might be willing to pay four or five times earnings
(for a P/E ratio of 4 or 5), realizing it would take that many years
to recover the purchase price. However, if you felt earnings had the
potential to increase significantly in future years, you might be willing
to pay a higher multiple of current-year earnings.

When considering public companies, it seems reasonable that
well-established businesses growing in a fairly predictable pattern would command
a higher P/E ratio than a small private business. Since you don't have
the risks or responsibilities that come with owning a business, you
would probably pay a premium. Typically, companies with higher growth
rates command higher P/E ratios.

The difficulty is deciding what a reasonable P/E ratio is for a
particular company or for the overall stock market. For individual companies,
investors' expectations about future earnings affect the P/E ratio.
Confidence that a company will improve its profitability or remain
profitable generally results in a higher P/E ratio. If profits are threatened
or weak, the P/E ratio is likely to drop. P/E ratios for the overall
market change based on broad market conditions and investors' views about
how desirable stocks are compared to other investments.

There is no absolute measure of what P/E ratio should be paid for a
given company with a given growth rate. P/E ratios can fluctuate
significantly over time and among companies and industries. It generally helps
to follow the P/E ratios of stocks that interest you, along with
companies in similar industries, to develop a feel for how the P/E ratios
fluctuate. Reviewing a company's P/E ratio for prior years can also be
helpful. If a company's growth rate in the past is expected to continue in
the future and market conditions are similar, you might not expect much
change in P/E ratios. But you also must evaluate whether changes to
the company, its industry, or the overall stock market would cause an
increase or decrease in the company's P/E ratio.

One way to evaluate P/E ratios is to consider a company's current P/E
ratio divided by its historical P/E ratio. If it is much lower than 1,
you might want to investigate why. It could mean the business is in
decline or having other problems. It may also imply that the stock is
reasonably priced now. If the value is much higher than 1, carefully assess
whether you want to invest at this time. You may want to wait until the
P/E ratio returns to a more historical level.

You can also divide a company's current P/E ratio by the market's
overall P/E ratio. If that figure is much higher than 1 (and thus higher
than the overall market), you should evaluate whether the company's
prospects justify that valuation.

This was an email sent to me by our Proffessor.