The P/E Ratio
How to Value Stocks
The Price-to-Earnings Ratio is one of the twin towers of The Fool Ratio. The P/E ratio (often simply referred to as the "P/E") shows the relationship between a stock price and its company's earnings (or profits) per share of stock.
Let's just get our hands dirty from the outset and calculate the P/E for Cindy's Snowshoes (NASDAQ:RAKD). Your daily paper shows you Cindy's stock trading at $20 per share. Your broker informs you that last year the company earned $1.00 per share. The P/E ratio? Right. 20.
Fine, you could do such calculations till the sun dips below the horizon, but just what the heck does the P/E mean?!
Well, for starters, note that the ratio expresses the stock price in terms of the earnings per share (EPS). The P/E ratio is a common measure of the value of stocks. Thus, we deduce (correctly) that the P/E uses the earnings of a company to value that company's stock. Simple and profound. By incorporating the P/E ratio into our model, we're asserting the validity of this notion. That is, we DO think the level of a company's stock price should largely be based on that company's profit-in-hand (here defined as total profits over the past 12 months).
The P/E ratio is such a widely used measure that the Market is obviously inclined to agree with us. Earnings are indeed at the heart of the matter of valuing a company's stock. Other measures exist, of course. You might wish to value a real-estate company's stock not off its earnings but off the value of its land. Or take dividends, the annual payments made by a company to holders of its stock. You might wish to value a company that pays a large dividend more off of the value of its dividend than its earnings. Other exceptions exist as well. But they are only exceptions. Users of the P/E ratio have a simple tool at hand that quickly values a company off of earnings.
OK, why earnings per share, then? Why not just consider earnings?
Remember that our ultimate goal is to value a stock, not a company. Stocks are priced per share. If the number of shares of a given stock suddenly inflates, all other things remaining equal, what will happen to the stock price? It'll drop. Same thing happens to earnings, of course.
And if earnings growth becomes outpaced by share growth, that's tainted growth, from an investor's point of view. That's often a losing situation. Always look at earnings per share.
So we close this section having learned how to calculate the P/E multiple, and having learned that Fools use earnings per share as a starting point for valuing stocks.
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