price/earnings ratio (P/E ratio

Introduction

Chances are you've heard the term price/earnings ratio (P/E ratio) used before. When it comes to valuing stocks, the price/earnings ratio is one of the oldest and most frequently used metrics. Although a simple indicator to calculate, the P/E is actually quite difficult to interpret. It can be extremely informative in some situations, while at other times it is next to meaningless. As a result, investors often misuse this term and place more value in the P/E than is warranted.

What Is It? P/E is short for the ratio of a company's share price to its per-share earnings. As the name implies, to calculate the P/E, you simply take the current stock price of a company and divide by its earnings per share (EPS).

P/E Ratio = current market price of the stock

Earnings per Share (EPS)

The price/earnings ratio (P/E ratio) provides a comparison of the current market price of a share of stock and that stock's earnings per share, or EPS (which is figured by dividing a company's net profits by its number of shares of stock outstanding). For example, if a company's stock sold for Rs.30 per share and it posted earnings per share of Rs.1.50, that company would have a P/E ratio of 15. A company's P/E ratio typically rises as a result of increases in its stock price, an indicator of the stock's popularity.

A company's P/E ratio is often viewed as an indicator of future stock performance. The high P/E shows that investors think that the firm has good growth opportunities, that its earnings are relatively safe and deserve a low capitalization rate, or both.

While accepting that a high P/E ratio is usually a sign of high expectations, analysts and brokers nonetheless are quick to caution that the ratios are only part of the puzzle. A company may post an artificially high P/E ratio as a result of factors that can either boost stock prices or diminish earnings per share. Restructuring charges,

merger and acquisition rumors (whether true or false), and high dividend yields all have the capacity to push a company's P/E ratio upward. In other instances, legitimately high P/E ratios can be adversely impacted down the road by such factors as market conditions, technology, and increased competition from new rivals (who may, in fact, be drawn to the industry by the company's previously posted P/E ratios).

Conversely, while a low P/E ratio is often a good indication that a company is struggling, appearances can again be deceiving. In addition, different industry sectors often have diverse P/E ratio averages. A company may have a fairly low P/E ratio when compared with all other corporations; when compared with the other companies within its industry, however, it may be a leader.

Finally, a company that posts a loss has no earnings to compare with its stock price. As a result, no P/E ratio can be determined for the company. Still, these companies may remain viable choices for investment if an investor decides that the company under examination is headed toward future profitability. In this case you go by the Price to Sales ratio. This metric looks at the current stock price relative to the total sales per share. You calculate the P/S by dividing the market cap of the stock by the total revenues of the company. You can also calculate the P/S by dividing the current stock price by the sales per share. The lower the P/S, the better the value, at least that's the conventional wisdom. However, this is definitely not a number you want to use in isolation.

Since so many factors can influence a company's P/E ratio, industry analysts caution against relying on it too heavily in making investment decisions. While a company's P/E ratio is a valuable and often accurate investment tool, if you're going to buy and sell stocks based on a P/E ratio, you're not going to make money. You'd better look at why it is high or low.

A general rule of thumb for investing states that a stock should sell at about its expected growth rate. For example, if a company's earnings were expected to grow at 12 percent per year, its stock should carry a P/E ratio of 12. In normal times, investors preferred to buy shares in companies whose fortunes were expected to improve in coming years. They'd shop for companies whose future earnings-growth rates were expected to exceed current price/earnings multiples.

EARNINGS PER SHARE (EPS)

Earnings per share is one of the two factors that determine a company's P/E ratio; the other is the price of the company's stock. EPS is derived by dividing a corporation's net income by the number of shares of total stock that are outstanding. A company with 30,000 outstanding shares of total share holding and a net profit of Rs.270,000 would thus have an earnings per share of Rs.9.

An essential part of determining the P/E ratio, earnings per share has also come to be regarded as an important piece of information for the investment community in and of itself. A primary concern of investors is how profitable a company is relative to their investment in the company. The investor is concerned with how net income relates to shares held and to the market price of the stock.... Only by converting the total amounts to per share data can a meaningful evaluation be made, because EPS figures can illustrate the degree to which a company's net income is keeping pace with its capital structure. In recognition of the importance of this information, corporations are required to report EPS amounts on their

profit and loss statement.