For many investors in the stock market, evaluating a stock for purchase is all about earnings (profits). This is a logical and valid approach to evaluating a stock since what you are buying is the ability of the company to grow earnings in the future.
A point here that should not be overlooked: if you are investing, you are mainly concerned with the future earnings of a company. If you a short-term trader, that future is only important in as much as it impacts today's stock price.
Stock investors use financial ratios to compare two companies from the same or different industries. If you want to buy a stock because of its high earnings, you need to know how much you are paying for those earnings and whether the same level of earnings could be bought for less.
When analysts or pundits talk about a stock being "too expensive" or "cheap," they are often referring to how the price per share relates to the earnings.
In other words, is the per-share price of the stock in line with the per-share earnings? The price/earnings ratio is one of the most often quoted calculations investors consider when buying a stock.
The mantra is "high P/E equals overpriced stock; low P/E equals bargain stock."
Unfortunately, it is not quite that simple.
To calculate the P/E, you need another figure: earnings per share (EPS). This is found by dividing the dollar amount of earnings by the number of outstanding shares. For example, if a company had $5,000,000 in earnings for the past 12 months and there were 10,000,000 shares outstanding, the EPS would be $0.50. $5,000,000/10,000,000 = $0.50
Another way to say this is each share of stock generated $0.50 in earnings. Is this a good or bad earnings per share? If other companies in this same industrial sector had EPS numbers that were significantly different, you might have a basis for comparison. A higher EPS indicates the company is generating more than $0.50 per share in earnings, so you a getting more for your invested dollar.
Once you have the EPS, compute the P/E by taking the stock price and dividing it by the EPS. For example, if a company's stock was $22 per share and the EPS was $0.50, the P/E would be 44. $22/$0.50 = 44
Without knowing anything else, an investor might assume from this example that the company is considered a growth company that would be expected to show significant earnings growth in the future. Another investor might say, "Whoa! This stock is too risky because it has no proven earnings potential."
While the P/E provides some general information, it is not specific enough to make an investment decision based on it alone. The "multiple" (another term for P/E) of a company is more helpful if placed in a context.
Many investors believe that P/Es should be looked at in relation to future growth. After all, investors pay for future growth and profits, and the P/E is a measurement of the past. To address this concern, it is helpful to look at another earnings ratio, the P/E and Growth Ratio (PEG). The PEG looks forward to future earnings growth.
The PEG is computed by taking the most forward earnings estimates, available from the analyst reports divide that into the P/E. If our company had a projected earnings growth rate of 15 percent for the next two years, its PEG would be 2.93: P/E of 44/EPS growth of 15 = 2.93
To put this in context, a PEG of 1 would indicate the stock was fairly priced because the P/E should roughly equal EPS growth. Our example shows the company is priced almost three times over its fair market value. Something else about this stock would have to be very compelling for an investor to consider it. If you use the Internet, many of these ratios are already computed for you or are a part of a stock-screening service.