How to Explain Profits-to-Earnings Ratio

Investors want all the information they can get before risking their money.

Investors want to get an idea about the value of a company's stock before they put their hard-earned money into it. The price-to-earnings ratio (P/E), sometimes mistakenly called the profit-to-earnings ratio, is "the most commonly used valuation measure," according to J.P Morgan. The P/E ratio gives a simple, clear indication of how much profit a company or stock index makes in relation to its stock price. However, investors must take other factors into consideration when using the P/E.

Things You'll Need

• Graphics showing P/E movements over time for a stock market index and one or more companies

Instructions

Defnitions

1. Provide the basic definition of the P/E ratio: It is the price of the stock divided by the earnings, or profits, per share. A relatively high number indicates profits are low compared to price, and a relatively low ratio suggests profits are high.

2. Give an example of two stocks that both sell for $10 a share; one has $2 per share profit and the other has $1. The stock that has higher profits has a P/E of 5 (10 divided by 2), and the stock that has lower profits has a ratio of 10 (10 divided by 1).

3. Point out that the P/E ratio can be calculated for stock market indexes as well as for individual companies. For an index, divide the market value of the index by the earnings per share for the last 12 months for the companies in that index.

4. Note that the P/E ratio can be figured for past years or for the current or upcoming year. The ratio for the future, sometimes called the "forward P/E ratio," is the forecast profit divided by the current price. It is sometimes used to predict if a stock or a market is an attractive buy or not.

Limitations

1. Stress that the P/E ratio must be examined in context. For example, an older company in a mature industry usually will have a relatively low P/E because growth prospects are steady but moderate. Companies in high-growth fields commonly have higher ratios because buyers have driven the price up in anticipation of growth.

2. Point out that often-used "forward P/E ratios" are only as accurate as the profit forecasts. If forecasts turn out to be too high, the ratio will be too low and the value of the stock or index will look deceptively high.

3. Explain that other indicators should be considered in addition to the P/E. Forbes magazine stated "the P/E ratio is just one aspect of the stock research process."

4. Note that one way to use the P/E ratio to pick stocks is to compare the ratios for comparable companies (see video in Reference 3). If the type of products, amount of debt and other factors are comparable, the one with the lowest P/E has the most value.

Tips & Warnings

• Use examples liberally. For instance, compare the P/E ratio for a company in a mature, slow-growth industry and the ratio for a company in a high-growth area.

• Be sure you emphasize that the P/E ratio is not a guarantee of future values for an individual stock or for a stock market.

References

• J.P. Morgan Asset Management: Glossary
• PBS Nightly Business Report; Stock Prices: Encouraging Signs in the Price-to-Earnings Ratio
• "Forbes"; Is a Low P/E Ratio Always A Steal?; Michelle Cerone; March 2011
• "Wall Street Journal"; Is It Time to Scrap the Fusty Old P/E Ratio?; Ben Levisohn; September 2010