The P/E Ratio – An Investors Favorite Tool

The Price to Earnings Ratio

The P/E Ratio is an Important Tool that Every Investor Should Look Into Before Making Decisions.

If you’ve ever wandered onto Yahoo! Finance, read the Wall Street Journal or watched CNBC then you have definitely heard things like “Walmart’s price to earnings ratio is…”, “Home Depot’s multiple…”, or “Caterpillar is trading at 10 times earnings.”

It may surprise you to know that each of these phrases is actually describing the same thing. Each statement is keeping up with a company’s Multiple, or the amount of times that an annual earnings per share can be divided into the market share price.

You are calculating how much more, in times, you are paying for a share than the company’s earnings for that share.

Example of a P/E Ratio

Why is this important? I will use an imaginary example to illustrate.

Let’s say that Caldwell Inc.’s shares are trading at $10.00 per share, and Leggett Co.’s shares are trading at $45.00.

Which one is more expensive?

At first glance you would say that Leggett Co. Is the more expensive share, but this is inaccurate and the multiple can show us why.

You see, the earnings per share at Caldwell Inc. was $2.00 per share last year. So that means Caldwell Inc. has a 5:1 P/E ratio ($10 divided by $2). It is trading at 5 times earnings.

Leggett Co. had earnings per share of $10.00 last year ($45 divided by $10). So Leggett Co. is trading at 4.5 times earnings.

What Does it Mean?

So let’s put this into perspective: would you prefer to pay 5 times what a car is worth or 4.5 times what a car is worth? Of course, 4.5 times is cheaper!

So even though numerically Leggett Co. appears to be more expensive than Caldwell Inc. when you utilize the Price to Earnings Ratio you see that it is actually quite the opposite!

And this is Important because…

When you are looking to purchase shares of any company, you should ALWAYS be comparing them to the industry and sector you find them in, as well as all of its major competitors. The P/E Ratio is a great starter’s tool for comparing companies’ prices.

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