What is a P/E ratio?

When you stop and think about it, mankind has invented many clever ways to compare various objects. We have scales to weigh things, numbers to count things, and even graphs to show how one mathematical function behaves relative to another one.

Consider comparing a basketball foul shooter who has made 79 out of 108 free throws versus one who has made 67 out of 80, just by looking at the raw data. The raw data isn't much help. What do we do?  Simple - calculate successful shots on a percentage basis. The first shooter has made 73%  of her shots and the second shooter has made 84% of her shots. Thus, we can conclude that the second shooter is a better foul shooter.

Rene Descartes

In the same way,  Rene Descartes (the very same "I think, therefore I am" philosopher) invented the cartesian co-ordinate system which opened up the field of analytical geometry by enabling mathematicians to visualize and compare geometrical figures and functions, by putting them into the same plane.

In the field of finance, DIY investors compare different investments. On the fixed income side, investors have to determine whether a 9-month certificate of deposit paying  a CD rate of 3.5% is a better investment that a bond with a 2-year maturity that has a yield- maturity of 4.1%. To compare the two, the investor puts the yields on a comparable basis.

P/E Ratio to Compare Stocks

In the stock market, the main tool for comparing two stocks is the P/E ratio - the ratio of price-to-earnings. Simply, the higher the P/E ratio, other things being equal, the more expensive the stock. In other words, the more an investor has to pay for a dollar of earnings.

The P/E ratio is a starting point. The next step in comparing 2 stocks would be to ask why the higher P/E ratio stock should be considered. To the investor, it is like asking why he or she should go to the movie theatre that charges $10/show rather than one that charges $8/show. Obviously there could be good reasons - the higher priced theatre has more comfortable seating,  less expensive refreshments, and so forth.

In the same way, there are good reasons sometimes to prefer the higher P/E stock--the most important being the prospects for growth. Simply, companies viewed as having good growth prospects will tend to have higher P/E ratios. Apple Computer will have a higher P/E than Procter and Gamble.

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To get a P/E ratio is easy. One way is to go to Yahoo Finance! and put in the stock symbol. For example, if you put in the symbol for Apple Computer, you find a P/E ratio of 23. Notice that this is based on the trailing 12 months of earnings (ttm). Earnings used in P/E ratios are for various periods, and the careful investor needs to ascertain the exact measurement for earnings. Sometimes it's expected earnings, sometimes it is normalized earnings, and so forth. Clearly, in comparing two companies, the DIY Investor needs to be sure he or she is making an apples-to-apples comparison.

P/E Ratio to Value Market

P/E ratios are not just used to compare two companies but also to assess the overall market. Here, for example, is a mention of P/E, in an excellent article on P/E by Paul J. Lim, and its relationship to inflation in this morning's New York Times:

Indeed, since 1871, the market’s P/E has hovered between 17 and 18, on average, in periods when inflation has grown at an annual rate of 1 to 3 percent. That’s well above the current P/E of about 13. 

The writer here is pointing out that, during periods of inflation similar to what is being experienced presently in the U.S., investors were paying more for a $1 of earnings (17 to 18x) compared to today at 13x.

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Investors who delve into market forecasts and the use of P/E in the overall valuation of the market eventually will come to the Shiller P/E, developed by Yale professor Robert Shiller. This P/E is based on the last 10 years and is adjusted for inflation.