The Rosetta Stone of Financial Ratios
What’s the P/E Ratio?
It stands for Price ÷ Earnings, which actually means “Price per share ÷ Annual Earnings per share”.
For example, if the stock price is $100 per share, and current annual earnings are $5 per share, the P/E would be $20.
It tells you how much you are paying for each dollar of annual company earnings, aka profits.
Another way to think about this number – it tells you how many year’s worth of current annual earnings are included in today’s stock price.
If current annual earnings are $5 per share, there are 20 years worth of those earnings in a $100 stock price.
In the book, I call this “The Rosetta Stone of Financial Ratios”. Why? Because in one number you learn a lot about what investors think of the company and expectations for FUTURE earnings. It also provides a way to compare companies across market caps and industries in a uniform manner.
More often, investors will compare the PE ratio of companies with similar businesses or to the average PE of a particular group of stocks.
Earnings seldom stay the same from year to year, rather, they tend to move up and down based on how well the business is performing. If earnings are expected to grow from year to year, this will factor into how much investors are willing to pay per $1 of earnings.
Stock analysts will spend considerable time debating whether a stock is a “good value” or if the price is “justified.”
Typically, they are debating if the PE is too high or too low given the company’s expected future earnings.
Remember, the market is almost always looking forward – or “around the corner” as I like to say in the book.
Let’s dig a little deeper into the concept. Here’s a hypothetical example of comparing two stocks.
• Earnings last five years of $10 per share each year
• Projected earnings next five years are $10 per share each year
• Dividend is $1 per year
• Earnings last five years of $0 per share each year
• Projected earnings next five years are $1, $5, $10, $20, $40
• Dividend – none
Which stock would you expect to have a higher PE ratio or multiple?
That all depends on how likely Company B is to achieve its earnings projections. The more the market believes those growth projections, the more likely the stock would have a high PE ratio. If the market doesn’t believe those numbers can be achieved, it may not pay much for the stock since the company hasn’t shown any earnings yet.
What’s the right price?
That’s what the market tries to figure out every day, based on the information available.
As you begin to think about stocks in the real world, start to pull up quotes on Yahoo Finance or another site. Look at the PE ratio on each one to begin to get a feel for how different stocks price. It will help you develop a sense of when things might be a good deal or not.
In our book, we walk you through an example with a "lemonade stand" business to help you understand the concept. We also compare the prices and earnings history of Apple and Netflix at the time of publication to help you see it with real companies.