Level: Beginner
Michael: Welcome to our third issue of the education blog! Notice that there is a line above that tells you the level of the education blog. Beginner means that it is intended for everyone, and usually the topics stay in line with our meetings. Intermediate is for officers and anyone else who is ahead in the meetings, while Advanced is for me to introduce or discuss topics that are currently out of the scope of the club. Our topic this time around is the P/E ratio. Ken will explain to you in simple language what the P/E ratio tells you, how it is calculated, and how it is used.
Ken: The Price-to-Earnings (P/E) ratio is a powerful tool that we can use to determine, on a basic level, how other investors feel about a certain company. To be more specific, it is a fundamental analysis ratio that measures how much money investors are willing to pay for one dollar of earnings. Low P/E ratios suggest that other investors are not as confident in a company as they should be and have therefore oversold the stock. On the other hand, high P/E ratios suggest that investors are overconfident in a company and have therefore overbought the stock. However, a single company’s P/E ratio by itself is useless. In order to gain insight on a company, we must compare its P/E ratio to that of other companies operating in the same sector (type of product or service). The P/E ratio is calculated as follows:
P/E ratio = Share Price divided by Earnings Per Share (EPS)
EPS = Net Income divided by Number of Shares
Translating that financial jargon into English:
- Net Income: The amount of money the company earned (usually in the past year)
- Average Outstanding Shares: The total number of a company’s shares owned by investors, whether retail or institutional
For example, XYZ had a net income of $200 million last year. XYZ has 100 million shares of stock, each priced at $50. The EPS for XYZ Inc. would be $200 million / 100 million = $2. Since the price is $50 and the EPS is $2, the P/E ratio would be 25. Let’s compare them to ABC, who operates in the same sector. ABC, with 50 million shares, made $150 million last year. Its EPS would therefore be $150 million / $50 million = $3. Each share is currently trading at $45, giving ABC a P/E ratio of $45 / $3 = 15. The P/E ratios of XYZ and ABC show that investors are willing to pay more for XYZ’s earnings than ABC’s earnings. Investors could also be valuing XYZ more than they should, causing XYZ’s stock to fall when the market corrects itself.
Therefore, P/E can be a powerful tool determining when a stock is overvalued or undervalued. However, just because a company’s P/E ratio is relatively low or high does not mean it is undervalued or overvalued. A company could be reporting outstanding earnings, but if it is taking on massive amounts of debt to get there, investors will not be as excited. This lack of confidence will drop the price, thus lowering the P/E ratio. When making trading decisions, use the P/E ratio in accordance with other fundamental ratios for the best result.
– Ken Croker