The P/E, is a ratio showing the relationship between the stock price and the earnings of a company. The P/E ratio is a useful measure to use to see whether a stock is overpriced, fairly priced or under-priced relative to a company's money-making potential.
The P/E ratio can be thought of as the number of years it will take the company to earn back the amount of investors' initial investment- assuming of course that the company's earnings stay constant.
The ratio is widely considered to be one of the most important ratios in finance.
Market Value per Share
Earnings per Share (NYSEARCA:EPS)
Let's say you buy 100 shares of company A for 6000. Current earnings are 6 per share, so your 100 shares will earn 600 in one year, and the original investment will be earned back in ten years.
That`s the fundamentals behind the P/E ratio, if we calculate the P/E ratio for company A using the same formula as above we will see that the P/E ratio will be 10.
60/6 = 10
Understanding the ratio:
If you surf into a stock site or any other site showing the P/E:s of listed companies you will probably find out that there are some stocks having P/E ratios of 50 and others having P/Es of 5. What does that mean in reality? It means that investors (The capital market) are willing to take gambles on the improved future earnings of some companies (P/E high), while they are quite skeptical about the future of others (P/E low).
The P/E ratio of a company is useful only in comparison to other companies in the same industry, to the market in general or against the company´s own historical P/E. It would for an example, not be useful for investors using the P/E ratio of a technology company (high P/E) to compare with a beverage company (low P/E) as each industry has different P/E standards.
Another interesting thing about the P/E ratio and which you probably will find out when you study companies, is that P/E levels tend to be lower for slow growers (companies that grows slowly) and higher for fast growers (companies that grows faster)
P/E in the practice
As understood by our examples above, a company with high P/E must have incredible earnings growth to justify the high price that is being put on the stock. There are many good examples both in modern- and ancient stock times with overpriced stocks falling sharply because over prissiness. This following example is taking from the bestseller "One up on Wallstreet" by Peter Lynch. It is exemplifying the decline in the share price of McDonald's in 1972 relating to its P/E ratio.
"In 1972 McDonald´s was the same great company it had always been, but the stock was bid up to 75 a share, which gave it a P/E ratio of 50. There was no way that McDonald's could live up to those expectations, and the stock price fell from 75 to 25, sending the P/E back to a more realistic 13. There wasn't´t anything wrong with McDonald´s. It was simply overpriced at 75 in 1972."
"Remember to avoid stocks with excessively high ones. You will save yourself a lot of grief and a lot of money if you do that. With few expectations, an extremely high p/e ratio is a handicap to a stock." - Peter Lynch, One Up on Wall street 1989
An incorrectly valued stock that is attractive because it's combined asset value is greater than its market capitalization
Understanding the concept:
An asset play is shortly described as a stock which is priced considerably lower than the value of its firm´s assets on a per-share basis. A paper company may operate in an extremely competitive market and earn minimal profits. Investors tend to focus on earnings and thus price the stock after its minimal earnings. However ,investors in this case have potentially overlooked some extensive and valuable timber, or real estate holdings of the paper company which are not reflected in the current share price (Which we assume is based on earnings only), therefore it is said that the particular stock is an asset play.
Peter Lynch explains "Asset plays" in the bestseller "One up on Wall street";
"At the end of 1976, Pebble beach was selling for 14.5 per share, which, with 1.7 million shares outstanding, meant that the whole company was valued at only 25 million. Less than three years later (1979) twentieth century-fox bought out Pebble Beach for 72 million, or 42.5 per share. What´s more, a day after buying the company, twentieth century turned around and sold Pebble Beach's gravel pit - just one of the company's many assets- for 30 million. In other words, the gravel pit alone was worth more than what investors in 1976 paid for the whole company."
Both the P/E ratio and the knowledge of Asset Play are important when analyzing stocks. While the P/E ratio is used to analyze the particular stock - or part of the company, Asset Plays are more important when looking into the company's balance sheet. This is why it is very important to do the homework and look into the balance sheet of companies, some companies may have different ways of valuing their assets why it is also important to look into the notes of the balance sheet.