How to use the P/E Ratio

Review of the P/E Ratio

In our last post we learned what the Price to Earnings Ratio was and how it related to the Multiple of a share.

For Reviews sake, you’ll recall that the Multiple can be calculated by taking the market price of a share and dividing it by the earnings per share of the company. This is because a share’s multiple is a calculation of how many times it’s earnings you will pay for the share.

So if a share is $10 and has $2/share earnings then the multiple would be 5 and it would have a 5:1 P/E ratio.

Using the P/E Ratio in Practice

When choosing stocks, you should not be taking stabs in the dark. Do your research.

So you’ll probably remember that I also said that a P/E ratio was an important part of your homework. It is even more important for choosing a stock though. We’ll go through how to use it for both of these purposes now.

When choosing a stock, you need to be comparing different companies within the same sector. For example: to understand if I should be buying Microsoft I compare it’s multiple to Google’s, Cisco’s and several other tech companies. Now I consider whether or not Microsoft is cheaper than these other companies.

Now — this is very important — in order to justify a purchase you MUST have a reason to assume that the price will be going up. If you cannot convince a friend exactly why this stock will be growing, do not buy.

Let’s say you’ve compared your stock to your sector, found a reason to believe it will grow (be it new management, product launch, simple under-valuing), you may just have found a winner!

Monitoring the P/E Ratio

For the purpose of homework, a P/E ratio must constantly be examined and watched; just as stock prices can be under-valued or a sector’s growth can under-perform an individual stock, stock prices can be be over-valued as well. If the multiple ends up very expensive then it can be just as important to dump the stock as it is to pick up a cheap multiple.

Hopefully this gives you a better understanding of how to go about using the multiple. I can promise you- this is not the last you’ll hear of it!