Part 1: Price to Earnings ratio discussion
Greeeaaat, how entertaining can this PE discussion be. I mean, we're talking about Price to Earnings (PE) ratios, man. Gnarly! Let's get to the point.
The PE ratio magically incorporates the following three things in one number:
These three pieces of information can be important to consider because investors want to make money (??):
Two simple ways to to calculate a PE ratio are:
Note that (Stock price) * (Total # of outstanding shares) is also called a company's Market Capitalization or Market Cap.
You end up with the same number in both (1) and (2), which you could prove by doing some simple algebra. But what does it all mean?
On Wall Street, people often look at the PE ratio to determine whether a stock is "cheap" or "expensive." Surprisingly, a $5 stock is not necessarily cheap and a $500 stock is not necessarily expensive. In general, lower PE ratios point to cheaper stocks and higher PE ratios point to more expensive stocks. Note that I prefer to use the terms cheaper and more expensive; reason being, I like to keep things relative where possible/appropriate.
There is no one perfect PE threshold that indicates stock cheapness. It's not so simple that we can say "Hey, this stock has a PE of 5 (or 10 or 15)... it must be a steal!!"
When evaluating if a stock is cheap, sometimes people just look at the PE number itself; sometimes they compare PEs among stocks within an industry or sector; sometimes people compare a stock's PE to the average PE of all stocks in the S&P 500 index. Also, some people say that high PE stocks are too risky for them; others say that low PE stocks do not offer enough upside potential to be worth their time and money.
People use the PE ratio in all sorts of ways, and the list goes on and on, but the bottom line is that it relates the company's stock price, # of outstanding shares, and annual earnings all in one "simple" number.
I hope I've got you hooked, because there's more to come in the next installment later this week!
The PE ratio magically incorporates the following three things in one number:
- how much profit the company makes in a year
- the stock price
- the number of outstanding shares
These three pieces of information can be important to consider because investors want to make money (??):
- Profit is important: the more profit, the better for the shareholder.
- Stock price is important: the lower I can buy the stock and the higher I can sell it, the better.
- The number of outstanding shares is important: when the company makes a profit, how big of a slice do my shares represent in the profit pie?
Two simple ways to to calculate a PE ratio are:
- PE = (Stock price) * (Total # of outstanding shares) / (Annual net income)
- PE = (Stock price) / Annual Earnings per share (EPS)
Note that (Stock price) * (Total # of outstanding shares) is also called a company's Market Capitalization or Market Cap.
You end up with the same number in both (1) and (2), which you could prove by doing some simple algebra. But what does it all mean?
On Wall Street, people often look at the PE ratio to determine whether a stock is "cheap" or "expensive." Surprisingly, a $5 stock is not necessarily cheap and a $500 stock is not necessarily expensive. In general, lower PE ratios point to cheaper stocks and higher PE ratios point to more expensive stocks. Note that I prefer to use the terms cheaper and more expensive; reason being, I like to keep things relative where possible/appropriate.
There is no one perfect PE threshold that indicates stock cheapness. It's not so simple that we can say "Hey, this stock has a PE of 5 (or 10 or 15)... it must be a steal!!"
When evaluating if a stock is cheap, sometimes people just look at the PE number itself; sometimes they compare PEs among stocks within an industry or sector; sometimes people compare a stock's PE to the average PE of all stocks in the S&P 500 index. Also, some people say that high PE stocks are too risky for them; others say that low PE stocks do not offer enough upside potential to be worth their time and money.
People use the PE ratio in all sorts of ways, and the list goes on and on, but the bottom line is that it relates the company's stock price, # of outstanding shares, and annual earnings all in one "simple" number.
I hope I've got you hooked, because there's more to come in the next installment later this week!
Leave a comment