Sunday, November 19, 2006
The price to earnings ratio
The price to earnings ratio
This is the most widely used ratio in finance not only because of its simplicity but because the figure can usually siphon the good from the bad. Take for instance Google, it sells for a Price to Earnings (or PE) of 63 while its rival Yahoo trades at just a 34 PE. Which is better?
PE ratios are simply price divided by the amount each share earns per year. A PE ratio of 20 simply means that the stock is worth twenty times what it is expected to earn each year. A company with a market cap of $100M and a price to earnings ratio of 20 earns $5M a year. Make sense?
Price to earnings is used all the time in real estate investing, or by entrepreneurs when they buy small businesses. Price to earnings is simply a return on investment calculation. You’ve probably used a price to earnings ratio when deciding on a new car.
Price to earnings ratios aren’t always accurate however. Some investors are willing to pay 65 times what a company is set to make because the company may have extreme growth rates. Google is a company which trades at high PEs but it offsets the high price by setting high growth rates.
Technology companies are usually those with the highest PE ratios while established companies like banks and companies with large market caps have low PEs. Citigroup, one of the largest banks in the world by assets, trades at a PE of 10. Obviously the larger companies usually have slower growth rates because they are already well established.
To balance the differences in earnings ratios, investors use a formula called Price to Earnings to Growth. Known as the PEG it is the price of each share, divided by each shares earnings, divided by the growth rate in percent. A corporation valued at $50 per share with a $5 earnings per share and a growth rate of 20% will have a PEG of one-half or 0.5.
Like price to earnings, the best PEG would be as close to 0 as possible. Investors generally consider 1 to be a good PEG number and worth an investment. Three to five would be a very high PEG and the stock would be a sell in the eye of an investor.
Both the PE and PEG are examples of fundamental analysis in today’s market. While the markets base worthiness on what someone is willing to pay, the PE and PEG seek value. A Corporation that makes $200M a year will not sell for $100M. This is just not something that the financial markets of today would allow. There will always be a certain range for investors to take. A PEG of 10 would not be a favorable investment for any one who is looking to invest for the long haul.
Value works. When you can buy what, in your opinion, should be a $10 stock for $5 you have created wealth. The PEG is a great outline to find true investments worth taking. Calculations like the PE and PEG help value investors such as Warren Buffett, the second richest man in the world, find companies that are worth an investment.
Experiment and identify companies with low and high PE ratios. You will find that PE ratios vary by sector but most stocks will fit in a very tight range for PEG figures. Yahoo finance provides both the PE and PEG already calculated for each stock on the exchange.