PE Ratio (Price to Earnings)

As a means of judging value, the P/E ratio is the most widely followed fundamental indicator and is partially a measure of current popularity. We say this because if there are a lot of buyers for a security, its price is likely to go higher. That will make for a larger P/E. Think of it this way. If a stock is trading at 20 and earns $1.00 annually per share, the P/E will be 20. If buyers come in and drive up the price of the stock to $30.00, the P/E will be 30 (assuming no change in earnings). The ratio is a peek into what the market perceives the future earnings of the company to be. If a company trades with a high P/E ratio, we can assume that investors are expecting strong future earnings growth.

A high growth stock will typically trade with a high P/E because the market expects a lot from future earnings. Thus, a drop in earnings or an earnings shortfall could cause a large price decline in the stock price. We see this all the time when companies miss earnings estimates. Can you say gap down?

Often, a lower P/E implies value. However, you must compare a company’s P/E ratio to its growth rate and to the other companies in the industry. If a company is growing their earnings, and is expected to continue to grow earnings, at 15% per annum while trading with a P/E of 10, this implies value. Also, if you find a company that is growing as fast as the rest of its group and trades with a lower P/E, this most likely implies value in the company. Keep in mind, however, if investors are abandoning ship and selling the stock, the price will most likely decrease, causing a lower P/E. This may or may not indicate value and it may or may not indicate trouble.

Print | E-Mail

Client Education

The Market Indicies

Our Rules and Tips

Definitions and Terminology

Stock Charts