Expert: Paul Henneman - 3/26/2004

Question
Hi Paul,

I am confused on how the PE ratio is formulated and the relevance it has to a stock. Could you please explain?

Thanks
Britt Duenyas

Answer
Britt,
  Thank you for your question!
  P/E ration is Price/Earnings. It is a good question, as this is one of the most common pieces of data to look at when considering an investment in a stock.
  Below is the definition of P/E ratio from the Barron's Dictionary of Financial Terms, they probably do a better job at a full description that I could. P. 465:

"P/E: Price of a stock divided by its earnings per share. The P/E ratio may either use the reported earnings from the latest year (called trailing P/E) or employ an analyst's forecast of next year's earnings (called a forward P/E). The trailing P/E is listed along with a stock's price and trading activity in dhte daily newspapers. For instance, a stock selling for $20 a share that earned $1 last year has a trailing P/E of 20. If the same stock has projected earnings of $2 next year, it will have a forward P/E of 10.
[my note: this does not refer to stock price gains of $1 or $2, but instead of earnings per share (earnings of the company divided by the number of outstanding shares)]
The price/earnings ratio, also known as the multiple, gives investors an idea of how much they are paying for a company's earning power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting. High P/E stocks- those with multiples over 20 -are typically young, fast growing companies.  They are far riskier to trade than low P/E stocks, since it easier to miss high-growth expectations than low-growth expectations."

Keep in mind that high P/E is not all the time a bad thing, if the company is growing quickly and that growth is expedted to continue. William O'Neil (from Investors Business Daily) has done alot of work to implement P/E ratio successfully into investment research and decision making. Any of his books go into more depth on how he has charted patterns in what to look for in P/E. Specifically, "The Successful Investor" by Mr. O'Neil goes into this. He actually argues, based on data he has collected, that the best stock investments have higher P/E ratios. This is because they are better companies with good earnings growth. He also states that you should not invest based only on P/E, but it is a variable to consider. It is a good read if interested.

I hope this helps! Please do not hesitate to follow up with me if I can be of any additional assistance.

Sincerely,
Paul Henneman
President
ValuEngine, Inc.
www.ValuEngine.com