P/E RATIOS DEFINED
Financial shop talk can be a confusing world, especially for new investors willing to venture beyond "high," "low," "sell," and "buy." University of Chicago professor Marvin Zonis offers a one minute explanation of the P/E, or Price/Earnings ratio and shows us one of the best methods to evaluate a stock.
The P/E ratio shows the price of a stock divided by its annual earnings per share. To calculate a P/E ratio (get your pencils ready), do the following:
1) Take the total profits of the company over the past year and divide it by the number of shares outstanding. This gives you the earnings per share.
2) Then divide the price of the stock by the earnings per share.
3) Voila! The result is the Price/Earnings ratio.
Now that you have this number, what can you do with it? The P/E ratio tells us what the market is willing to pay for anticipated earnings in the future. For example, if a stock is selling for 30 dollars and earned 5 cents a share, its P/E ratio is 600. At current earnings of 5 cents per share, a company would have to earn that amount for 600 years to justify the stock price. Finacial advisors always tell us to invest for the long term, but 600 years is a long time. What this means is that investors expect a sharp increase in earnings that will soon (as in sooner than 600 years) pay off. On the contrary, a low P/E ratio may indicate that investors expect little growth in a company's earnings.
To see if a stock is overvalued or undervalued, you need to compare its P/E ratio now to its P/E ratio in the past, you need to compare it to the ratios of other companies in the same sector, and to the whole market. Professor Zonis shows us that P/E ratios can be very helpful in making wise investment decisions, but beyond that, good investing still requires research, hard work, and an educated investor.
To hear Professor Marvin Zonis, from the University of Chicago Graduate School of Business, talk about P/E Ratios, check out our One Minute MBA video clip. Just click the appropriate connection speed in the video box on the right column of this page.