The price of a stock like anything else should be evaluated on what it rewards its owner. The rewards of owning a stock is the earnings of a company, the potential of future growth and supporting the positive impact to society provided by the company. The earnings of the company need to be evaluated with how much the company’s valuation. The total earnings is expressed as Earnings Per Share or Earnings/Share (EPS). It is calculated by adding up the earnings of a company in the last 4 Quarters of the year ( trailing twelve months/TTM) divided by the total number of outstanding shares. EPS is expressing for each share how much income it is earning.
No two companies will have exactly the same EPS and same stock price. To compare two companies, we need the unit cost of each EPS unit. This is similar to finding which item cost less at two grocery stores. For example one grocery store sells 6 oranges for $3 and another store sells oranges at 5 oranges for $2.20. To find out which is the better deal you need to compare what each orange cost.
store 1 $3/6 oranges = $.5 per orange.
store 2 $2.20/5 oranges = $0.44 per orange.
We take the price and divide it with number of oranges. To compare the relative cost of a company, we need to do the same thing. We take the stock price and divide it by the EPS. This gives us the price per EPS. This is the Price to Earnings ratio or PE.
We can compare PE of two companies in the same industry to see if one is a better deal than the other. We can also compare a company’s PE against the average PE of the companies in its sector of the economy. The PE can also be compared w/ the average PE of major indices like the DOW, S&P 500, Nasdaq or Nasdaq 500. When a company PE is significantly outside of the averages, it could indicate it is more expensive. The extra cost should be justified and raises questions. Is company growing faster than its peers ? Is the company in its early life cycle? On the other hand, if PE is below the average PE, it could indicate a great bargain or it could be a sign of trouble and investors have lost confidence. Is growth slowing or is company facing some difficulties such as tougher competition? Is it experiencing a cash crunch and having difficult time raising funds. That latter is red flag and indicate potential bankruptcy risk.
We can also calculate the PE based on future estimated earnings to see where its PE might be in the future. The forward PE uses the next 4 quarters earnings estimates from analysts that cover the company and guidances provided by the company instead of the trailing 4 quarters. A falling forward PE may be a good sign the earnings is growing and the company is heading in the right direction. This will depend on the quality of the earnings. Earnings might come from cost cutting. This could provide near term boost to earnings at the expense of hurting future product development or sales expansion.
In summary the PE is an important metric and useful tool in evaluating an investment.