From Joshua Kennon,
Your Guide to Investing for Beginners.
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Value investors have long considered the price earnings ratio (p/e ratio for short) a useful metric for evaluating the relative attractiveness of a company's stock price. Made popular by the late Benjamin Graham, who was dubbed the "Father of Value Investing" as well as Warren Buffett's mentor, Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis.

An explanation of the price earnings ratio

Before you can take advantage of this tool, you have to understand what it is. Simply put, the p/e ratio is the price an investor is paying for $1 of the company's earnings. In other words, if a company is reporting basic or diluted earnings per share of $2 and the stock is selling for $20 per share, the p/e ratio is 10 ($20 per share divided by $2 earnings per share = 10 p/e.)

Confused yet? No need to be. Most stock-quote systems such as Yahoo! Finance will automatically figure the price earnings ratio if you ask for a detailed quote on any company.

Once you have the magic number, it's time you begin to wield its power. It can help you differentiate between a less-than-perfect stock that is selling at a high price because it is the latest hot-pick on Wall Street, and a great company which may have fallen out of favor and is selling for a fraction of what it is truly worth.

First, you have to understand that different industries have different p/e ranges that are considered "normal". For example, technology companies may sell at an average of 40 p/e, while textile manufacturers may only trade at an average of 8. There are the exceptions, but for the most part, these differences between sectors are perfectly acceptable. They arise out of different expectations for different businesses; tech stocks usually sell higher because they have a much higher growth rate and earn high returns on equity, while a textile mill, subject to dismal margins and low growth prospects, will trade at a much smaller multiple.

One way to know when a sector is over priced is when the average p/e ratio of all of the companies in the industry is far above the historical average. (A sector is a group of companies in a particular line of business; e.g., pharmaceuticals, advertising, utilities, etc.) This could spell trouble. We saw the repercussions of just such a gross-over pricing in the recent technology crash following the dot-com frenzy of the late 1990's. Thus, the investor could have avoided the huge declines in the technology stocks had you sold when you realized the entire industry was dangerously expensive.

Using the p/e ratio to compare companies in the same industry

In addition to helping you determine which industries and sectors are over / under priced you can use the p/e ratio to compare the prices of companies in the same sector against each other. For example, if company ABC and XYZ are both selling for $50 a share, one is not more expensive than the other. Wrong!

Company ABC may have reported earnings of $10 per share, while company XYZ has reported earnings of $20 per share. Each is selling on the stock market for $50. What does this mean? Company ABC has a price to earnings ratio of 5, while Company XYZ has a p/e ratio of 2 1/2. This means that company XYZ is much cheaper on a relative basis. For every share purchased, the investor is getting $20 of earnings as opposed to $10 in earnings from ABC. All else being equal, an intelligent investor should opt to purchase shares of XYZ; for the exact same price ($50), he is getting twice the earning power.

The limitations of the price earnings ratio

Remember, though, just because a stock is cheap doesn't mean you should buy it. If a company's stock price has fallen, do your research and discover the reasons. Is management honest? Are they losing key customers? Look at insider buying. Is the Board of Directors buying stock in the company? If the weakness is across the entire sector or just because of temporary bad news that doesn't change the bottom line, then consider buying.