Can someone please explain in idiot proof form exactly what a p/e ratio is and how it works?

Question

I know it is price/earnings but cannot work out what it means or what its relevance is. Surely yield is more important?

Answer 1

The P/E ratio is simply the price of one share of stock divided by the annual earnings per share for that company. So, for example, if the stock is $40/share and the company's earnings are $2/share, the P/E is 20.

What does it mean? It just a rough estimate of whether a stock is cheap or expensive. Basically it's telling you how much you have to pay to get $1 of earnings. As a stockholder, you are part owner of the company, so what matters most in valuing a company is its earnings (current and future). For a company with a P/E of 20, you are paying $20 for every $1 of earnings. For a company with a P/E of 10, you are only paying $10 for that same $1 of earnings.

So, generally, lower is better. But a fast-growing company with a P/E of 20 is better than a slow-growing company with a P/E of 20. Why? Because the earnings for next year and the year after, etc. will be higher if the company is growing rapidly.

I would say that yield is NOT more important. That doesn't tell you much about how the company is performing, only how much they pay out to shareholders in dividends. Let's look at an example:

Company A has a stock price of $60, annual earnings of $4.80, and is paying 60 cents in dividends (for a yield of 1%).

Company B has a stock price of $60, annual earnings of $2.40 and is paying $2.40 in dividends (for a yield of 4%).

If I'm a long-term investor, I'd much prefer company A. Not only is it earning twice as much for every dollar I've invested (8 cents vs. 4 cents for company B), but they are keeping 7 cents of that to use in order to grow the company. Company B is paying out every cent they make in dividends, which leaves them nothing to use to grow their business. Yes, company B is paying more in dividends today, but five years from now, Company B's stock will still probably be around $60, while Company A's will likely be much higher because their business will be much bigger and their earnings much higher.

Answer 2

The p/e ratio is the inverse of the yield. If the yield is 4%, the price/earnings ratio is 25. If the yield is 10%, the price/earnings ratio is 10.

Mathematically, pe = 1/yield

or expressed differently:
p/e ratio is price/earnings
yield = earnings/price

Answer 3

Actually, I would say that P/E is one of the most overhyped ratios for evaluating a stock. "Price" doesn't include a debt or cash position - Enterprise Value (the market cap. minus cash and equivalents plus long-term debt) should be used instead.
Also, "Earnings" hardly gives an accurate picture of how well the company is doing, because it is highly dependent on management's accounting techniques and subject to all sorts of one-time gains and losses. The better measure to use is adjusted free cash flow. If you follow the substitutions, you should be using EV/FCF instead of P/E. Its a bit more involved, but in my opinion, the bit of extra work involved in finding it are completely worth it.
Here is an example of what I mean by the difference between earnings and free cash flow. It uses Google (GOOG) as an example... http://www.valuestockreports.com/022507.htm

Answer 4

Price of each share divided by corporate earnings per share.

You are buying corporate earnings and want to pay the lesser posible price for them
So when P/E is high, the stock is overvalued, and less atractive for buying.
When low, its undervalued and is attractive for buying.

Be careful, stocks may remain overvalued/undervalued longer than you can remain solvent.

Answer 5

Do you desire to understand one of the reasons normal Law of attractionmaterial doesn't work for so many people?Believe of it like a diet plan. If you desire to drop weight and you strive to lose it