Investor's Guide

Understand price-earnings ratios and earn


Q: A friend of mine has recommended a stock to me, but it is trading at more than $100 per share. Wouldn't I be better off investing in a lower-priced stock like $20 per share that has more upside promise?

A: Suppose I tell you that Company A's stock is selling for $20 per share and another stock in the same industry, Company B, is selling for $120. Which would you rather buy?

The right answer is "I don't know." The reason I didn't give you nearly enough information to determine which company's stock you should consider buying. On its own, the price per share of a stock is meaningless.

While Company B's stock is selling for six-times as much per share, suppose its profits are also six-times as great per share. The level of a company's stock price relative to its earnings or profits per share helps you calibrate how expensively, cheaply or fairly a stock price is valued.

The stock price per share divided by the company's annual earnings per share is how you determine the price-earnings (P/E) ratio. P/E ratios can be calculated for individual stocks as well as entire stock markets.

Suppose you have a choice between investing in two companies, and both company's stocks are selling at a P/E of 15. If one company's revenue and profits are growing 40 percent per year and the other company's revenues and profits are flat, which would you buy?

Because they are both trading at a P/E of 15, the fast-growing company appears to be the better buy. Even if it just continues to sell for 15 times earnings, its stock price should increase 40 percent per year as its profits do.

Remember that just because a stock price or an entire stock market seems to be at a high price level doesn't necessarily mean that the stock or market is overpriced. Always compare the level of a stock to the level of that company's profits, or the overall market's price level to overall corporate profits. The price-earnings ratio captures this comparison. Faster-growing and more-profitable companies generally sell for a premium (higher P/Es). Also remember that future earnings, which are difficult to predict, influence stock prices more than current earnings, which are old news.


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