What Does Price to Earnings Mean to You?

The P/E basically looks at the stock price and company earning relationship. The P/E is the most popular metric of stock analysis. You calculate it by taking the share price and dividing it by the company's earnings per share (EPS). This is the company's net revenues divided by the outstanding shares.

For example, if the company has a share price of $50 and a EPS of 10, it has a P/E of 5. You can also look at this as the price an investor is paying for $1 of the company's earnings.

But what does this actually tell you? The P/E lets you know what the market might be willing to pay for the company's earnings. The higher the P/E, the more the market will pay. Some investors read a really high P/E as a sign of an overpriced stock, but it could also indicate that the market is optimistic of the stock's future and has bid the price up accordingly.

A low P/E could indicate that that the market does not have any confidence in the company. But it could also mean that it is just a sleeper that has been overlooked right now. Many investors make a lot of money simply spotting these value stocks before they are discovered by the market.

How do you know what the right P/E is? It depends on your willingness to pay for the earnings. If you believe the company has good prospects, you may be willing to pay more for a higher P/E. Another investor may not see the company in the same way and think that the P/E for it is all wrong for their portfolio.

Different industries often offer different P/E ranges in their "normal" range. For example, a tech company may sell at an average of 40 P/E, while a textile company may have an average of only 8. These are usually acceptable differences between the sectors.

You often do better comparing a stocks P/E to the historical average of the sector. You don't want to see the entire sector with an average P/E well over the historical average. This is a sign of overpricing.

Let's look at an example. Company LLL and Company DDD are both in the same sector. They both are selling for $50 a share. But there is a difference between the two companies.

Company LLL has a EPS of $10 a share, while DDD has a EPS of $20 a share. Company LLL has a P/E of 5, while Company DDD has a P/E of 2 1/2. Company DDD is cheaper on a relative basis. For every share purchased, the investor is getting $20 of earnings on DDD, but only $10 in earnings from LLL.

Remember, that this isn't the only number in consider a stock. You need to look at the company's stock price history, management and other factors. Cheap isn't always better.

Martin Lukac www.MartinLukac.com , represents www.RateEmpire.com , an Internet consumer banking marketplace. RateEmpire.com is a destination site of personal finance, investing, taxes and mortgage rates. RateEmpire.com provides mortgage guides and financial rates and information. RateEmpire.com also operates a financial portal #1 American Financial, found at www.1AmericanFinancial.com

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