Ask different investors and you’ll
probably get different answers.
In the simplest terms, the
price-to-earnings ratio is the
dollars that you pay for each
one-dollar of earnings.
It’s calculated by dividing the
price per share, by the past 12
month’s earnings per share. You will
get the same answer by dividing the
market cap by the company’s total
earnings for the past four quarters.
When you determine this number, make
sure not to accidentally use the
earnings from only the last
quarterly income statement, or 10-Q,
filed with the SEC.
On Jan 31, 2000, the average P/E
of the S&P 500 was 25.6, and the
Nasdaq 127. These numbers have
fallen considerably since then, to
about 18 for the S&P and 49 for the
Nasdaq. Companies that have lost
money in the past four quarters have
no P/E ratio.
It is better to use forward
estimated earnings for comparison if
a company is growing at an
accelerated pace, since the past 12
months may be quite different than
what is projected for the coming
year. But if you choose to use the
estimated forward earnings rather
than the trailing earnings in your
comparisons, you’re working with
guesses instead of facts.
If you stop to think about it,
even a 20 to 1 ratio is hard to
justify. If a company is earning a
net 5% on sales, it would take 20
years to earn a full return on your
money, even if the company was
paying out all earnings as
dividends.
In reality, companies use
earnings to redeem bonds and repay
loans. They pay guaranteed dividends
to preferred shareholders and keep a
cash reserve to meet the business’s
current needs if sales slow. They
need funds for research and
development, and expansion of the
business. Your share of the
earnings, the dividend, might not be
much after these priorities are met.
“Value” style investors look at
the P/E ratio as a major indicator
of the fair value of a stock. If the
number is lower than the average,
they say that it may be a bargain.
If the ratio is higher than the
average, they say that the stock is
probably overpriced.
I agree that if other important
factors are weighed along with the
P/E ratio, a healthy company in a
growing industry with a low ratio is
definitely a bargain. If you limit
yourself to “undervalued” companies,
you will miss the best stocks.
Most of the biggest winners in
the past years have been stocks with
HIGH P/E ratios, even before they
made their biggest moves upward in
price, including Microsoft,
McDonald's, Home Depot, and
Wal-Mart. AOL had a P/E of 100 in
1994, and then rose 14,900% by Dec
1999.
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When placing orders through
your on-line broker, create
a paper trail of all
transactions. If you lose
money because a trade was
not executed, present copies
of your evidence to your
broker, asking for swift
reimbursement of your loss
due to their negligence.
If you don’t obtain
satisfaction, arbitration is
your next step. Overall, 60%
of cases considered by
arbitrators go in favor of
the customer and against the
brokers. If your loss is
substantial, consider hiring
an attorney.
Make a habit of
printing out the information
on your web browser screen
when you place an order.
This may be the only way you
can prove that you placed a
buy, sell, or limit order at
that time. |
Other Stock Market Basics Topics:
-
Stock Market Investing – the
Right Way
-
More Stock Marketing Investing
-
How to Pick Winning Stocks
-
The Golden Rule of Investing
-
Avoid Psychological Traps to
Have Successful Investing
-
Changes in Stock Values Can Be
Big Numbers
-
How to Invest Smart
-
Stock Advice - Important Selling
Rules
-
Poor Stock Buying Decisions
-
Market Indicators
-
Stock Market Cycles
-
When a bear stock market may not
be a bear market
-
Stock Index Futures
-
Four Things that Affect Stock
Valuation
-
What is a P/E ratio?
-
Value Investing
-
Cheap Stocks
-
What is a Financial Statement?
-
Analyzing Financial Statements
-
Stock Market Tip - Red Flags to
Look For When Investing?
-
The Annual Report – How to Read
-
Stock Market Analysts – Stock
Market Advice and Tips
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