What is a company’s Price to Earnings (P/E) Ratio?

The P/E Ratio is just one of the many evaluation metrics used by investors to determine the value of a company’s stock.

The P/E ratio of the stock determines how much premium an investor is paying for a company’s profits.

Lets look at a couple of examples:

Intel (INTC) Currently trading at \$20.16

Based on the company’s latest 10-Q statement, the company made \$2.29 per share over the past 12 months:

Here we are showing the company’s EPS (earnings per share) over the last 5 quarters as shown by Scottrade. This information can be found on nearly any broker’s page, or on a company’s 10-Q Statements found on the SEC’s EDGAR website.

\$0.58 + \$0.54 + \$0.53 + \$0.64 = =\$2.29

If we take Intel’s current stock price of \$20.16 and Divide it by the company’s EPS over the last year, we get the company’s P/E ratio:

\$20.16 ÷ \$2.29 = 8.8

This is the Company’s ttm (Trailing Twelve Month) P/E ratio because it is calculated using the company’s earnings from its last twelve months. A forward P/E ratio can be calculated based on the forecasts for a company’s earnings in the future as well. However, this calculation is only as good as the estimates for the future, so take great caution in investing based on someones assumptions about the future.

A company’s P/E ratio is shown on yahoo finance, and just about any other financial site

What does it mean for Intel to have a P/E ratio of 8.8? It means as an investor, the price for you to purchase that company’s stock is 8.8 times their annual profit.

Lets say you want to buy the gas station up the street from you, and it makes \$1 million  per year. More than likely the owner will not sell it to you for only \$1 million, because he will make that amount of money next year alone. So you have to offer him a premium for his business. If you offer him \$8.8 million, you are giving him a P/E ratio of 8.8 (just what Intel has), or  8.8 times his annual profits. He is most likely much more likely to take that offer.

Some companies trade for much higher P/E ratios. For example look at Facebook:

A P/E Ratio of 114!

Why do some people pay such outrageous premiums for stocks like Facebook?

It is because they expect significant growth in the company’s future profits. Investors today are expecting Facebook’s profits to increase well over 20% per year. Will this happen? No one knows, but remember my word of caution earlier about investing based on people’s assumptions of the future.

Going back to our local gas station example. We said earlier that if you bought the gas station that makes \$1 million a year for \$8.8 million, you are giving it a P/E ratio of 8.8, valuing it as investors are valuing Intel today. Now, plug in Facebook’s numbers and we see that investing in Facebook today is like paying \$114 million for that same gas station!
So what is a better deal? That should be pretty obvious. You would much rather pay \$8.8 million for \$1 million a year in profits than \$114 million for that same \$1 million annual profit.

Investors in Facebook today will only be successful if Facebook can significantly increase its profits.

From a value investing standpoint, Intel offers a much better deal because you are paying much less of a premium for the company’s profits. Intel will more than likely provide a slow and steady return for years to come, where as investors are betting that Facebook will explode higher in the coming years.

In general, the lower the P/E ratio is the more valuable the company’s shares are because you are paying less for the company’s profits.

It is important to note that P/E ratio is just one metric used to value stocks, and no investment should be made on just a company’s P/E ratio alone.  A low P/E ratio can also be a sign of impending financial trouble for the company, such as significant decrease in future earnings.

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