Nancy B King

Price-earnings ratio (P/E, PE) is one of those investment terms you frequently hear and sometimes use but may not fully understand. P/E (pronounced “PE” rather than “P and E”) is a tool for evaluating whether a stock is overpriced, underpriced, or fairly-priced.

What it is

• P/E is a ratio, a relationship, between a stock’s price-per-share (P) and the company’s earnings-per-share (E). Earnings refers to the company’s net profit, the money the company made after it paid all expenses including taxes.

If a company has lost money (has not made a profit), it will not have a P/E because it has no earnings (E).

• You can find a stock’s P/E listed as part of its online price quotation. Note the following online quote for McDonald’s:

On this date McDonald’s had a P/E of 16.38. The data service automatically calculates the P/E—closing price-per-share ÷ earnings-per-share. In the term P/E (ttm), the (ttm) stands for ‘trailing twelve months.’ It means the earnings-per-share figure used to calculate the P/E is the total earnings for the four most recent quarters.

• A stock’s P/E indicates investors’ assumptions about the company’s ability to grow its earnings. The greater the anticipated earnings growth, the higher the P/E. Because of the company’s perceived earning power, investor demand for the stock drives up the stock price, which in turn drives up the P/E. The company may or may not be able to meet investors’ expectations. Is the company actually a high-powered racecar with plenty of gas and able to grow its earnings 40 to 50 to 55 percent a year? Or, will the company run out of gas or suffer a loss of power and grow by only 18 to 20 percent a year?

• P/E signals the premium investors are willing to pay for the company’s perceived earning power. Chipotle Mexican Grill (CMG) has a P/E of 25.77; investors are spending, in theory, $25.77 for Chipotle’s ability to grow its earnings. Red Robin (RRGB) has a P/E of 12.35; investors are willing to pay only $12.35 for Red Robin’s capacity to increase its profit. Investors are willing to spend more for Chipotle’s earning ability than Red Robin’s ability because they believe Chipotle’s earnings will grow substantially faster than Red Robin’s.

• P/E states how many times greater the stock price is than the company’s earnings. This  comparison is called the price-earnings multiple (multiple). A P/E of 12 means the stock price is 12 times greater than the company’s earnings—a multiple of 12. Chipotle’s P/E is 25.77; its stock price is almost 26 times its earnings—a multiple of 25.77. The higher the multiple, the greater the expectation for a rapid increase in earnings.

Try It

Check the P/Es of various companies. Which company has the highest P/E? Which has the lowest P/E?

Step-By-Step

1. Go to http://finance.yahoo.com/q?s=MELI You will find the current stock quote for MELI. It will look similar to the quote below that lists MELI’s P/E as 72.59.

2. Enter the following symbols and check each company’s P/E: Microsoft (MSFT), Apple (AAPL), Johnson and Johnson (JNJ), Wal-Mart (WMT), and Dyncorp (DCP).

3. What did you find out about the P/Es of the above companies?

◊  Which company is expected to increase its earnings the least, or which company has the lowest P/E?

◊  Which company is expected to grow its earnings the most, or which company has the highest P/E?

◊  For which company are investors willing to pay the highest premium for the company’s expected ability to grow its earnings?

In Conclusion

A stock’s P/E, by itself, merely reflects investors’ demand for the stock based on their perception of the company’s ability to increase its earnings.

Looking Ahead

The next topic will be about using P/Es to help you determine whether a stock is under-, over-, or fairly-priced.

Sadly saying good-bye to the Christmas season as I begin to take down the Christmas decorations. In some cases a lifetime of memories put away until next year.

I just finished reading Churchill by Paul Johnson. On page 87 I came across this—

On December 13, 1931, crossing Fifth Avenue in the dark, he looked the wrong way, as in England, and a fast car, coming from the opposite direction, knocked him down. He was badly damaged on the head, thigh, and ribs, and in terrible pain. But he remained conscious and when a policeman asked what had happened insisted it was entirely his own fault. He was in fact lucky to be alive.

—-which brought to mind a family story.

My grandfather loved to read and often sent his copy of a favorite book to the author to be autographed. This he did with Churchill’s The Unknown War—one of the books from Churchill’s Five volume history of the First World War. Grandfather didn’t hear and didn’t hear from Churchill but didn’t think too much about it because after all Churchill was a busy man. Then much later, Grandfather received his book autographed by Churchill with a note of apology and explanation that he had been carrying the book when he has hit crossing a street in New York City.

The Unknown War

The Unknown War was a part of my every day life through junior high and high school for a very practical, non literary reason. I can remember Mother cautioning me to carefully clean around it. She recounted its story several times. No, I have never read it, but am intrigued now after having just read Churchill and because my father fought in World War I.