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Price-To-Earnings Ratios Reflect Market Sentiment

by Amy Buttell / May 16th, 2011

Like EPS, the price-to-earnings or P/E ratio is a number thrown around in the financial media. But what exactly is a P/E ratio and why do you need to understand it? Basically, to calculate the P/E ratio, divide a company's stock price by its earnings per share (EPS). The resulting number is a widely accepted measurement of market sentiment toward a particular company. Just as earnings numbers vary depending on how they are calculated, stock prices change, too. As a result, the P/E is a constantly changing measurement and can be calculated in a number of ways depending on which type of earnings and what stock price is used.

The basics

Let's walk through the math. If ABC Company has a price of $60 per share, and its EPS is $3 per share, you calculate the P/E ratio like this:
$60 ÷ $3 = 20
The P/E ratio of 20 is what investors are willing to pay for the earnings of ABC Company. Basically, they are willing to pay 20 times ABC Company's earnings to own stock in this company. This amount might be more—or less—than investors have paid in the past. It might also be more—or less—than investors are paying to own similar companies or companies in the overall stock market.

The price factor

Many investors are confused by P/E ratios because they see so many different figures quoted for the same company. You could look at several financial publications and financial websites for a company's P/E ratio and get four or five different numbers. And none of them would necessarily be wrong or any more correct than the others. Basically, a company's P/E ratio changes frequently because its price changes constantly. Stock prices change from minute to minute when the stock exchanges are open. P/E ratios aren't that useful if calculated from minute to minute, so generally investors calculate and use them based on a certain period. Investors might use the high and low price of a stock over a year's time to calculate a high and low P/E ratio for that year. Once that's done, you can use those two figures to find out an average P/E ratio for an entire year. Because companies operate on differing fiscal years that may or may not align with the calendar year, it's a good idea to calculate P/E ratios using a company's fiscal year rather than the calendar year.
Because investors pay for future growth, it can be useful to estimate a company's future P/E.
For example, many retail companies have a fiscal year from Feb. 1 to Jan. 30 so that the entire Christmas season—a retailer's biggest selling time—is included in one quarter's financial results. Therefore, when analyzing a retail company, it's wise to calculate high and low P/Es from Feb. 1 to Jan. 31 rather than from Jan. 1 to Dec. 31. Other companies may have fiscal years beginning on July 1 and ending on June 30—the variations are endless. Basically, using fiscal-year high and low leads to more realistic, consistent P/E ratios.

The earnings factor

EPS is a slippery figure. Just make sure you know which earnings type is being used in a P/E calculation so that you understand what the ratio is telling you. For example, if you use basic rather than diluted earnings in a P/E calculation, the P/E figure may be artificially low, as it doesn't account for all the potential shares outstanding that could be included in a company's share count. By not including these potential shares, the earnings are spread out over fewer shares compared with the diluted figure, increasing the EPS figure. And assuming the stock price doesn't move, as EPS increases the P/E decreases. The traditional P/E ratio is based on what's known as trailing earnings. Trailing earnings are the last four quarters of a company's earnings. P/E ratios can also be calculated for future earnings periods. Since investors pay for future growth, it can be useful to estimate what a company's P/E might be in the future. To do this, you'd need to use future earnings estimates or a combination of past results and future earnings estimates, using the stock's current price. P/E ratios from the past—historical P/E ratios—can tell us what a company's P/E ratio has been in the past. Some companies have a range of P/Es that are characteristic of that company, while other companies have P/Es that vary widely.

P/Es in context

P/Es are an important measure of investor sentiment toward a company. Because investors prefer companies with strong, predictable earnings, these companies will command a higher P/E ratio than those of companies with more volatile and less predictable earnings.
A company's P/E ratio changes frequently because its price changes constantly.
They also reflect investor sentiment toward the economy and market in general. When the economy is booming, stock P/E ratios are generally higher than when the economy is in a recession. For example, overall P/E ratios in the stock market were historically high during the bull market of the late 1990s. Investors became accustomed to higher stock prices and were willing to pay up for companies with the highest growth potential. When the stock market fell into a bear market in 2000, however, P/E ratios contracted. The prices of virtually all companies fell, and astute investors were able to pick up some bargains among growth companies that had falling stock prices along with the rest of the market. Historically, P/Es have had a relationship to interest rates and inflation. When interest rates and inflation are higher, P/Es tend to fall because investors are getting higher interest rates for investing in bonds and are typically less attracted to stocks. When interest rates and inflation are falling, investors are more willing to assume the risks inherent in stocks in order to take advantage of potential capital appreciation. This attitude leads to P/E expansion in the overall market. P/E ratios are also very sensitive to a sector's favor in the market. When a sector is in favor, P/E ratios for a majority of companies in that sector tend to be higher. When a sector is out of favor, P/E ratios for companies in that sector tend to retreat.
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This article was originally published by BetterInvesting. Since 1951, BetterInvesting has helped more than five million people become better, more informed investors. BetterInvesting helps its members build wealth through educational webinars, Web-based mutual fund and stock tools, in-person learning events, publications, an active online community, and software. For more information, visit the website or call 877-275-6242. Neither CUNA nor the author of this article is a registered investment adviser. Readers should seek independent professional advice before making investment decisions.
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