Any good financial adviser will tell you that investing in stocks is a risky business, but you can use metrics to bend the odds a little more in your favor. One such metric is the price-to-earnings, or P/E, ratio created by Peter Lynch; it helps investment analysts compare intrinsic stock value with market value. Used in conjunction with a stock chart, this ratio can be used to predict future earnings.
The P/E ratio is calculated by dividing the price of a company with its earnings. For example, if the stock price of a company is $50 and the earnings per share for the year are $2, the P/E ratio is 25x. This means the company's stock price is trading at a multiple of 25 times the earnings per share of the company.
Interpreting the P/E Ratio
Analysts use the P/E ratio by comparing it to other companies in the same industry. Think of the P/E ratio as a price tag: A high ratio means the price of the stock is priced high relative to other stocks in the same industry, and a low ratio means the price of the stock is priced low relative to other stocks in the industry. For example, if the industry average for P/E ratios in the fast food industry is 25x, a company with a ratio of 15x is considered underpriced compared to the amount of earnings received per share. This might lead an investment analyst to conclude the stock was undervalued and prompt a purchase order until the P/E ratio is 25x. For our example, assume the P/E ratio for the industry is 25x and the earnings per share is on an upward trend, from $1 in the first quarter, or Q1, to $2 in the second quarter, or Q2, and $3 in the third, Q3.
A stock can be charted over any given period, while earnings per share are generally only reported quarterly and annually. For this reason, you should use a stock price chart with a quarterly or annual time frame. For our example, we'll use a quarterly measurement. Assume the stock chart shows that the stock price has gone up from $20 in Q1, to $25 in Q2, to $30 in Q3 and it looks like it's approaching $35 in Q4. You want to predict earnings for Q4.
The first step is to calculate the P/E ratio for Q1, Q2 and Q3. Then take that average and apply it to the average stock price in Q4. Using the prices and earnings in our example, the P/E ratio is calculated for Q1, Q2, and Q3 in the following way: Q1 P/E ratio = Q1 Stock Price / Q1 Earnings = $20 / $1 = 20x, Q2 P/E Ratio = Q2 Stock Price / Q2 Earnings = $25 / $2 = 12.5x; and, Q3 P/E Ratio = Q3 Stock Price / Q3 Earnings = $30 / $3 = 10x. The downward trend in P/E ratios is telling you that the stock price of the company is not keeping pace with the earnings in the company, and you may have an opportunity to purchase the stock at a discount. The average of these three ratios, 14.2x, is calculated by multiplying 20x by 12.5x by 10x and then dividing by 3. The calculation is: (20x * 12.5x * 10x)/ 3 = 14.2x Assume your stock chart shows stocks increasing to $35 in Q4. Divide the stock price by the average P/E ratio for an earnings prediction. In this case, the calculation is $35 divided by 14.2x, or $2.47 earnings per share for Q4. This number should be considered an upper limit, because the price chart shows an upward trend, and an average was used in the example calculation.
Sharon Barstow started her career in investment banking and then crossed over to the world of corporate finance as a financial analyst. She specializes in banking and corporate finance topics to include treasury management, financial analysis, financial statement analysis, corporate finance and FP&A. In addition to writing, she is the co-owner of a small dog bakery in rural Ohio.