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Price to Earnings (P/E) Ratio - Calculating Earnings Growth & Relative Value of Stock Prices

The Price to Earnings ratio compares the current price of a common stock trading on the market with the Earnings per Share (EPS) that the company yields. Earnings per Share is calculated by dividing Net Income in current quarter by the total # of shares outstanding on the market. The price to earnings ratio is a widely used stock valuation tool as it indicates to investors how 'cheap' or 'expensive' a stock is and you will see analysts on Bloomberg television referring to the P/E ratio in part of their analysis & discussions about stocks. For example, assume Farhan Corp. currently has its A Class common stock trading at $45 per share and total # of shares on the market is 50,000. Net income as at February 28th, 2010 is $2million. What is the Earnings per Share?

Earnings per Share = Net Income / Total # of Shares Outstanding

Earnings per Share = $2,000,000 / 450,000 shares
Earnings per Share = 4.44 cents a share

Having this data, what will be the Price to Earnings ratio?

P/E ratio = Current Price / EPS

P/E ratio = $45 / 4.44
P/E ratio = 10.135

Earnings per share data of a stock is commonly found in Google Finance or from the annual reports of your prospective company. Another way to derive Earnings per Share is to estimate based on the EPS of last 4 quarters.

Disadvantages of using EPS

1) The price to earnings ratio is based on future estimates of earnings or net income such as the prevailing estimate of EPS of the last 4 quarters. With the high volatility in the stock markets and lots of businesses going bankruptcy, future estimates of accounting earnings or net income should be taken not very seriously as they are just estimates and could be way off from actual performance.

2) Economic conditions change very fast and since the Earnings per Share is sometimes calculated using last 4 quarters' EPS, this may not fully represent the Current earnings of the company and could be subject to high volatility. Price to earnings ratio calculated in this manner is known as the 'Trailing P/E."

3) The earnings per share tells us about the current profitability of the company but does not tell us anything about the future. For instance when the company sells a huge asset such as a building or land, this will result in a jump upwards in the EPS. Likewise when the company uses cash to purchase a huge capital asset such as plant & equipment or land, this will result in EPS going downwards.

Understanding the Price to Earnings Ratios of Companies

N/A = A company with no net income or earnings has a N/A P/E ratio and the stock could be a penny stock or a very high risk company.

1 - 12 = The stock is moderately or significantly undervalued or the company's earnings are projected to go down.

13 - 20 = The stock is fairly valued and could be a value buy for most investors.

21 - 29 = The stock is significantly overvalued or the company has significantly increased its earnings in the past quarter or few quarters.

29+ = The stock is significantly overvalued and may be subject to a speculative 'bubble' that could burst really fast. Investors buying such stocks should be cautious and look at the long term prospects of the company and if it can grow earnings at its current pace, otherwise the stock could take a huge hit and investors will lose money.

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