## Thursday, January 19, 2012

### Boring Terms We Need To Know: P/E Ratio

Price-to-earnings ratio (P/E) is one of the first stock analysis terms people learn about.  It's a very simple calculation that gives you an idea of the current valuation of a company based on its earnings.  Although it is a simple metric and one most people will say they understand, there is more to just knowing that the lower the P/E ratio the cheaper the valuation of the stock.

For those of you who are beginners lets take a quick look at the calculation.  P/E is just as it appears, price divided by earnings.  Typically you will see (TTM) when viewing a P/E ratio, this stands for Trailing Twelve Months.  In other words, it is using the stock's earnings for the most recently reported 12 months.

The P/E ratio represents what an investor is paying per dollar of earnings.  So a company trading for \$24 a share that has TTM earnings of \$2.00 has a P/E (24/2) = 12.  Buying shares of that company means you are willing to pay \$12 for every \$1 of current earnings.  So the lower the P/E ratio, the less you are paying for each \$1 of earnings the company is currently making.

When running a dividend stock through my analysis, I use P/E in my "Fair Value" section.  I compare what the stock's current P/E is vs its 5 Year Average (this can be found at morningstar.com under the valuation link).  My purpose for this comparison is to see whether a stock is currently trading below its average P/E valuation.  This gives us an idea of if we are getting the stock cheaper now in terms of earnings than we could have in the past.

But it's not just what a stock is currently valued, it's also what its future valuation is.  A company can have a high P/E ratio and still be a good buy if it has a high growth rate as well.  For instance, if a company is selling for \$30 a share and has earnings of \$1.00 it has a P/E of 30.  This certainly seems high, but if that company's earnings growth for next year is expected to be 50% (\$1.50 in earnings), then its forward P/E = 20.  And this is mostly what investors buy stocks for, not its current valuation but its future valuation.  You buy a stock based on what you believe it will earn in the future, not the present.  That is where the second part of my "Fair Value" section comes in, PEG ratio.  I'll explain that in an upcoming "Boring Terms" post.

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