What is pe ratio?

queestionHow can you tell when you’re talking to an investor who probably loses a lot of money?  They look at the price of the stock as a way to analyze.  Let’s just say it right away:  If you use the price as an analysis tool, you probably don’t know how to analyze.  If you are asking, what is pe ratio, then you are on the right track for a better portfolio.

 

Yes, I know that I’m making a statement that might offend some but I’m saying it for your own good.  The price is important but not until you have already decided to buy or sell.  I want to introduce you to probably the most important part of your beginning analysis.  If you answer the question, what is pe ration, you are going to take a huge step forward in understand the true value of stocks.

 

P/E stands for Price/Earnings Ratio.  Before I go in to the technicals, here is an example you can easily understand.  Remember when you purchased your last car?  You may have asked friends and family for opinions and maybe your favorite sister told you that you should buy the new Honda Civic LX.  She said to get the LX because you didn’t need power windows, moon roof, GPS, leather seats, and 4 doors.  And who needs air conditioning anyway?  She paid $19,000.  Your best friend loves Hondas as well but he just bought a brand new Honda Pilot EX.  Fully loaded, all the bells and whistles.  GPS, high end sound system, car alarm, leather, tow package, moon roof, upgraded tires, and everything else possible.  His new car is a luxury vehicle.  He paid $40,000 for his.

 

You take all of this information and go home to talk to your wife.  You decide that to compare these vehicles by looking only at the price.  None of the characteristics of the cars are important to you other than that so you purchase the Civic LX because clearly it’s the better value since it’s $21,000 cheaper than the Pilot.

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What’s wrong with your analysis?  The problems are clear.  The Pilot is more expensive because it’s a bigger vehicle with a more powerful engine and it’s loaded with options that will surely increase the resale value.  You would be a fool to only look at the price and not pay any attention to what you’re actually paying for.  This example seems so clear but if you only look at price, that’s exactly what you’re doing.  But looking back at our question, what is pe ratio, how does this relate to that?

 

The Price/Earnings Ratio is the number that allows you to ask what you are getting for your money.  It is simply the amount of money that investors are willing to pay for every $1 of earnings.  For example, if a company were currently trading at P/E of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.  The best way to use it is to compare companies in the same sector.  So let’s make up some numbers.  Let’s say that Google has a P/E of 52 where Yahoo has a P/E of 15.  First, we ask why investors are willing to pay $52 for every dollar of earnings when they could pay $15 per $1 for Yahoo.  Google has a much brighter future for earnings than Yahoo in every way so the stock costs more.  In short, Google is a better company and it has a balance sheet to prove it.  (NOTE, these are examples only.  You should not take this as a reccomendation to buy)

 

What is pe ratio?  It allows you to compare apples to apples.  You cannot compare P/E ratios of companies in different sectors.  (Don’t compare a computer company to a restaurant, for example)  Sometimes you can find a company with great fundamentals that has a low P/E compared to its peers.  When you find that, buy it.  Of course the other way can be true.  High P/E with problems on their balance sheets.  That’s why this evaluation tool is important.

 

This is only the very tip of the iceberg with P/E.  You can Google it and find numerous other articles that go in to much more detail.  Post your questions about P/E here.

Analyzing stocks is difficult to learn.  Once I started reading books like the one above, I felt much more confident.  Click here to go to the elementary finance bookstore to order your copy. You can also take a look at the book in the box above.

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