P/E Ratios

P/E Ratios

The Price/Earnings ratio is one of the most common ratios used to evaluate stocks. It can be calculated by taking price per share / earnings per share (yearly) or taking market capitalization / net income (yearly). The number it yields shows the market value per dollar the company generates as income. For example, if a company's P/E ratio is 25, then the company makes $1 every $25 of stock. If earnings for the last 4 quarters are used, then it's known as a trailing Price-Earnings ratio. Projected earnings can also be used to project a projected P/E ratio. It's important to remember that earnings are often based on accounting earnings, which may be biased one way or the other. A large gain from discontinued operations, for example, may deflate a company's P/E ratio.

Old, well-established companies will generally have low P/E ratios while newer, growing companies will have higher P/E Ratios. This is due to expectations of future earnings. Well-established companies have fairly predictable earnings while small, growing companies are expected to have higher earnings in the future.

Examples of trailing P/E ratios (as of 2/13/06):

  • Micron: 125
  • Google: 61
  • Amazon: 56
  • Yahoo: 55
  • Apple: 36
  • S&P 500: 21.7
  • Walt Disney: 21
  • Microsoft: 20
  • General Electric: 18
  • Walmart: 18
  • AT&T: 16
  • Sun Microsystems: -48
These were taken from morningstar.com.

As you can see, P/E Ratios have lots of variation. Remember that you can't always take them for face value. Micron, for example, makes computer chips (like RAM) which is a very volatile industry. Last year's earnings were barely in the black, but this year's could be very large or very negative. Sun Microsystems lost money and that's why their P/E ratio showed up negative. Usually websites will show "N.A." instead of posting negative ratios.

You can see that Google, Amazon, and Yahoo are high on the list. This is due to the fact that they are internet companies in a growing industry. Investors expect high profits in the future from them. During the internet boom of the late 90's, many high-tech companies consistently had P/E ratios near 100 (if they weren't negative!). When investors finally realized that their earnings weren't going to improve, high-tech stocks took a big plunge and P/E ratios dropped.

The P/E ratio of a company should be compared with those of similar companies to best determine whether the stock is over or under valued. P/E ratios should also be used in tandem with P/B ratios to get a good idea of what the price of a stock should be.

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