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The PE Ratio

If you’ve ever tried investing in stocks, this is probably the first number people mention. If you pull up any ticker, like MSFT, you’ll see this number:

P/E Ratio

So what is it?

What Is The PE Ratio

On the surface, the P/E ratio is how much the company is currently worth on the market, divided by the amount it made last year. For example, if the stock was $20/share, and the company made $1/share, then it has a P/E ratio of 20. Or, if you take another perspective, if the same company has a market capitalization of $2 billion and made $100 million last year, that’s still a P/E of 20.

So formula wise PE ratio = Current Price Per Share/Earnings Per Share
= Current Market Capitalization/Earnings For The Company For The Year

So all that is good, but now you have a number like 20. What does it mean though?

What The P/E Ratio Means

Most people would just take that number from each company and just start comparing it to other companies. They’ll say like “Oh, this company has a P/E of 5, and this one a P/E of 20, so the one with the P/E of 5 is cheaper!” That’s actually not really true, and we’ll see why when we look at what that number actually means!

Let’s take a realistic example to put things into perspective:

Let’s say you decided to invest $1200 into an arcade business. The model of the business is that you put arcade machines in shops, and collect the money once in a while when it’s full. Luckily, you have an uncle who owns a barbershop, so he lets you put it there for free. While people are waiting in line to get their haircuts, they put in money to play your arcade machine. Every once in a while, you empty out the money. Consider the following scenarios:

You empty it out once a year and finds that it makes $600 on average. In this case the price you bought the business at ($1200) divided by the earnings of the business every year ($600) is 2. So in this case, your P/E is 2 – 2 years. This means that if the business continues making the same amount of money as it does now, you’ll get your money back in 2 years.

You empty it out once a month and finds that it makes $50 on average. In this case, you’re making the same amount of money per year ($600), so your P/E is still 2 years! However, if you did price ($1200) divided by earnings per month ($50), you’d get a P/E of 24. That 24 is 24 months though! It’s saying at the current rate of $50/month, it’ll take you 24 months to get your money back.

You have a partner, who invested in this business with you, so you both contribute $600 and get one share of the company. In this case, the yearly earnings of the “company” would still be $600, but since there’s two shares, the earnings per share is $300. Since the price of your original share is $600, the price per share ($600) divided by the earnings per year per share ($300), so the P/E is still 2 years.

Price Earings Ratio Considerations

- Remember the units of the price earnings ratio. When it’s listed, it’s normally in years, meaning the number of years to get your money back assuming nothing changes. However, when dealing with a low or fractional P/E, it might be useful to talk about P/E in terms of the # of months.

- Things can change, which is why there are other figures like the forward P/E (price divided by how much the company expects to make the next year). It’s also why the P/E can vary greatly depending on how much it’s expected to grow or decline. For example, a company about to go bankrupt may have a P/E of 0.05, while a company expected to grow a lot can have a P/E of 100. Just remember that the P/E number listed reflects price / last year’s earnings.

- In our example above, we didn’t figure in taxes, so if you had to pay tax on that $600 you make every year, the P/E would go down. Mainly, just pay attention to what the earnings # is. In this case, you can separate it out into a pre-tax P/E and a post-tax P/E.

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One Response to “What Is The P/E Ratio And What The Price Earnings Ratio Means”

  1. Roshni Bhatia on February 20th, 2012 3:14 am

    An understanding of P/E ratio is very important for normal investors before taking any investment decisions. Thanks for putting up this article which explains the significance of P/E ratio very clearly.