Introduction
The P/E
The p/e of a company’s stock is its price/earnings ratio, also known as the multiple
- To a buyer of stocks, the p/e is a measure of how many dollars must be paid for each dollar of a company’s earnings
- The better the prospects, the higher the p/e
- The price/earnings ratio, or p/e, is an important consideration in deciding whether to invest in a company’s stock. It is a reflection of a company’s potential and its popularity.
- The p/e is simply the ratio of a company’s price to its earnings. Specifically, it is the stock price divided by the earnings per share. For example, if a company is projected to earn $1 billion this year and has 500 million shares outstanding, its earnings per share (eps) would be $2.
If the stock price is $20 per share, the p/e multiple would be 10 ($20 price divided by $2 eps). As a buyer of this company’s stock, you are paying ten dollars for each dollar of current-year earnings.
- As you might guess, the better a company’s growth prospects, the higher the p/e ratio. Let’s look at two companies, A and B: both are expected to earn $1 per share in the upcoming year, but A’s earnings are not expected to grow over time whereas B’s profits are projected to grow 20% a year.
It stands to reason that you would be willing to pay a higher p/e multiple for Company B’s earnings. After all, in ten years, Company B would be earning over $6 per share, whereas Company A’s earnings would still be only $1 per share.
The difficult question is how much higher a p/e should you put on a great company vs. a mediocre company. The easy answer is that truly great companies are usually great investments, as well.
