Understanding the PE Ratio Formula
The PE ratio is a classic stock evaluation metric that gets a lot of attention. Open up any finance magazine or article, and it’s usually one of the first numbers you’ll see. While the formula itself is straightforward, its importance lies in what it can reveal about a company’s future potential and investor confidence.
Simply put, the PE ratio is calculated as:
P/E Ratio = Price of a Share / Earnings per Share
You’ll often see it written as “P/E ratio” or just “P/E.” It’s also known as the “price multiple” or “earnings multiple.”
Let’s use AT&T as an example to understand this better:
Keep in mind that stock prices fluctuate constantly due to investor demand, while the earnings part of the equation is more stable and can be based on various accounting methods.
So, why is the PE ratio so popular? Investors use it to gauge whether a company’s shares are under-valued or over-valued. For instance, if you were to buy my blog, My Money Design, which makes $10,000 per year, at $50,000, the PE ratio would be 5.0. If the price were $100,000, the PE ratio would be 10.0. Obviously, a lower PE ratio seems more attractive, but that’s not always the case. The ideal price is what someone is ready to pay for it. If I wanted $100K but only got $50K, it might imply that buyers aren’t optimistic about the blog’s future. Conversely, if someone was willing to pay $100K, it might indicate confidence in the blog’s potential.
Using a more concrete example, the P/E ratio of AT&T (T) is 27.5, which seems high. AT&T’s current EPS (Earnings Per Share) is $1.29, but it’s expected to grow to $2.51 in a year. This expectation of higher earnings drives up the stock price, resulting in a high PE ratio now. The forward P/E is 13.17, suggesting that if the stock price stays the same, the P/E would lower with increased earnings, showing potential for a good buy.
What’s a good PE ratio? There’s no clear-cut answer. The best use of the PE ratio comes from comparing a stock’s current PE to its historical data or to other stocks within the same industry, not across different sectors. Historically, the median PE ratio for S&P 500 stocks is around 15.
In conclusion, the PE ratio can provide valuable insight:
– A high P/E Ratio can indicate strong future growth expectations.
– A low P/E Ratio might suggest a company is undervalued.
– No PE Ratio usually means the company isn’t profitable yet.
The key takeaway: Always look at multiple factors; a single metric like the PE ratio doesn’t tell the whole story. Use it in combination with other metrics for a thorough analysis.
