Price to Earnings Ratios
- A price to earnings ratio or P/E is a number that reflects the current stock price value. The current stock price divided by the TTM (Trailing Twelve Months) Earnings gives you the P/E ratio. For example if a company earns 1 billion net incomes and has a market cap of 10 billion (100 million shares x $10.00 share price) the P/E ratio would be 10. (10 billion market cap/ 1 billion net income = 10) Understanding a companies P/E ratio is a very valuable tool in determining how long the PEG payback for a company is. (PEG payback = Double Your Money)
- The P/E ratio is a rough estimate, if net income for TTM and the stock price were to stay the same it would roughly take that amount of years to earn your money back, not factoring in compound interest from dividends. That being said the lower P/E ratio is not always better and it can be what is known as a “value trap”. Sometimes very fast growing companies trade at higher P/E multiples or a premium for the distinct reason they have, are, and going to keep growing at a rapid pace over the next few years. P/E ratio can be a very tricky number to determine what is too cheap or what is too expensive of a price or multiple. I compare it with the S&P 500 TTM P/E ratio and try and find value companies with P/E ratios fewer than 15 but above 5. (There are exceptions for both) Some very reputable companies trade at a premium for a reason, and are worth it. (Coca-Cola, Pepsi, Kraft, Google, and many more.)
- Price to earnings ratios is only one fundamental analytic tool and has to be accompanied by others to get more accurate interpretations of companies financial conditions. Don’t worry if you aren’t very good at math you can use a calculator or reputable research engines like Morningstar. Price to earnings can be distorted by stock depreciation/appreciation, or one time write offs attributing to larger then normal net income, and it is always a good idea to get a second quote and look at 10 year financial multiples.