P/E ratio.....do i understand this correctly?

Question

isnt a lower P/E a better investment?.....a share costing $500 has yielded $10 a share over the past 12 months, is a P/E of 50........if the share cost $1000, the P/E is 100, a lower return with higher investment.

am i right?

Answer 1

The PE ratio is a practically meaningless statistic for comparing two companies that are not very similar. It is useful for looking at trends within a company and for comparing similar companies -- and that is about it.

Using PE has many problems -- the biggest one being that it ignores growth potential. Consider two companies that both have a stock price of $10.00. Suppose that both have projected earnings of $1.50 per share. Which is the better stock to buy? Now suppose that I add this fact -- the first company has an estimated growth rate of 3% and the second company has an estimated growth rate of 15%. Can you tell which one is better now?

PE ratios of growth firms tend to be high because estimated earnings are way off in the future. PE ratios of mature firms tend to be low because the cash flows are more steady.

Ratio analysis is a tool that can help people make better decisions -- but it is far from perfect. When used by someone who does not understand the implications it will lead to bad decisions.

Answer 2

You have made a few small errors. You confuse earnings with dividends. The P/E is as you discribe it however it is not a measure of the payout to share holders. It is the money earned per share. What is earned vs. what is paid out in dividends can be very different. However you are correct that a company with a lower P/E is a good value in theory only. Yes a company with a lower P/E can be a good value but it can also be a sign of trouble. I have seen companies with a P/E of 1. They were on the way down the drain. By the same token a company with a very high P/E ratio may not be a good place to invest in if you have an interest in growth.

Yes it is one of my screening methods as I never bother with stocks much over 7 on the P/E. On the other hand I always want to know why its as low as it is. It could be the company is undervalued. It could also be that it is because the company is small. It could be the stock is out of favor for some meaningless reason. Speculators can be sooooo fickle. It could be on its way south into the nether regions of stock market fire and brimstone. So in a nut shell yes you have the right idea. Just be carefull in your stock shopping.

Answer 3

As mentioned in other answers, generally a low P/E can indicate an undervalued stock or one you are not paying an over-inflated price for. However, the mention that a low P/E means the investment is 'safer' is dangerous.

P/E's are generally quote as Price divided by the most recent period's earnings. That is an historic indicator. We all know that the market tends to price future expectations into stocks. Therefore, if you have a stock that is trading with a P/E of say, 6 that may seem low and 'safe' however, the market is anticipating the next year to be a difficult one for that company. Therefore, the P/FE or Price divided by Future Earnings may be a lot higher with room for that price to come down further. Don't be under the illusion that a low P/E means safer.

Answer 4

The P/E ratio is the price of the stock divided by the Earings Per Share (EPS) so if the stock price is currently trading at $15/share and has a EPS of $2.00 it has a P/E of 7.5 (15/2). Typically a lower P/E is assoicated with an undervalued stock. The P/E ratio should be one of the many factors you look into when looking at a stock. To find a good P/E ratio make sure you compare the ratio with like companies in the same industry. P/E ratios for each industry tend to be different because of the structure of the industry.

Answer 5

P/E is used to calculate a companies price to earning ratio (that is what it is) but it does not mean necessarily that a company will give you a lower return with a higher investment. The market sets different levels of where a P/E for a stock should be based on the industry it is in as well as the growth rate of that company and/or industry. You need to compare a company's P/E to other like companies in its business to get an idea of this.

Answer 6

P/E menas Price/Earnings per share and not yield as you say. Yield is for bonds or debt instruments. Reciprocal of P/E givens the return on Investment, short hand method to calculate ROI.

Answer 7

Absolutely correct but today we work in terms of projected P/E in place of Past P/E that means Earning per share is computed for coming 4 quarters and then we use projected P/E for making investment decision but we also check how many times company is able to match its Projected EPS in the Past. Infosys is a Great exmaple of outperformance....

Answer 8

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Answer 9

yes...lower PE is in theory better...means you are not over paying for a stock...It means the investment is safer...Does not mean its a better investment.
But hot stocks tend to have higher PE's since they are forward looking...while old stalwarts tend to have lower PE's say ALCOA or one of those big food companies...because they aren't growning anymore.