Taking a Look At PE Ratio

Many of you may have heard of a PE Ratio (price to earnings ratio) before. This post will provide background information and an introduction to this fundamental analysis statistic.

P/E Ratio stands for Price to Earnings Ratio. It is one of the most common statistics used to determine whether a company is fairly valued, under valued or over valued.

Just like many other financial statistics you will come across, this one provides some good information but can be complicated to fully interpret, and to understand the company's current valuation level.

To determine a company P/E Ratio, you take the current share price and divide it by the Earnings per share over a 12 month period. The "P" portion of this statistic is the easy one, whatever the current share price is. The "E" part is another story. Typically, earnings per share from the previous 12 months are used which is going to give you a historical P/E ratio because you are using data from the past.

P/E Ratio

In some instances, you will hear "Forward, Leading or Projected PE Ratio". The calculation used for these are typically determined using some previous Earnings Per Share data with some estimated future Earnings per Share data. The problem with this is that it is relying on analysts estimates of future earnings.

This may be fine with an analyst that has a long proven track record, but many times this is not the case. This doesn't mean the PE ratio cannot be used in your analysis. It just means that you should be aware of it's possibility of being incorrect and to not fully rely on any one statistic alone.

Note: another method used to determine a PE Ratio is by taking the market capitalization divided by the net income over a 12 month period. This works out to the same as using the current share price divided by earnings per share over the same 12 month period.

Another thing to keep in mind is that different industries will have different "normal", or "fairly valued" historical PE Ratios. For instance, a company in the Automotive Industry will have a different historical P/E Ratio compared with a Computer Software company. Be sure to compare apples to apples.

When trying to determine a fair value for any particular company, be sure to not only check the company itself, but it's competitors as well. This will help you (but not always fully) determine, how fairly it is priced compared to it's peers.

You can also look at it's historical statistics to see how fairly valued it is currently trading at compared to previous time periods. This can vary though due to different growth rates occurring within the company itself.

When comparing two companies in the same industry, sometimes there may be a wide difference between the two valuations. This does not necessarily mean one is more fairly valued than the other though. One may have had a different growth rate and earnings over a period of time. It is important to keep in mind the future potential earnings power of each company itself.

As history has shown us, one of the problems with relying on financial data and statistics is that it is partly compiled by humans. Unfortunately, this has led to misleading information on more than one occasion. Any misleading information that is unknown would make the financial statistics useless.

In addition, companies may do their books slightly differently from each other, producing varied results across competitors. Be sure to keep this in mind when relying on any data and statistics.

In conclusion, using any financial statistics while performing fundamental analysis should not be relied upon by themselves in my opinion. A typical in depth analysis will include several statistics and then an analysis including potential future metrics as well.

This doesn't mean that using a PE Ratio does not have it's place when doing your analysis. You should keep good records of your findings for each particular stock and use that information to determine it's accurateness and the proper weighting you should give it in you complete trading or investing plan.

A great place to get financial information, both historical and estimates is by using a service like this: Morningstar Investment Research: Free Online Trial. 4,000 In-Depth Reports, Ratings. Data on 20,000+ Stocks and Funds.. They have both a free and a premium service that has plenty of useful information for doing all types of analysis.

You can also find P/E Ratios for industries at places like Yahoo Finance as well as specific stocks Yahoo Finance.

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