Recently, I received a lengthy email from a reader who had a ton of basic personal finance questions contained within. I thought it might be interesting to start an irregular “personal finance 101″ series to answer and explain some of her questions.
This question is worth quoting:
What does P/E mean? I understand a stock price but why do people keep talking about P/E?
P/E is a simple statistic for individual stock investors that allows you to easily compare companies that are in the same business. Here’s an example of how it works.
At the end of the last fiscal year, Whirlpool (WHR) reported that their company earned $5.67 per share. This means that for every share of stock of Whirlpool, the company earned $5.67.
Today, Whirlpool’s stock price is 88.91. Thus, dividing the price (P) by the earnings per share (E) gives you the P/E ratio: 15.69.
What about forward P/E? Instead of using the company’s last reported earnings per share for the calculation, forward P/E uses the estimates of Wall Street analysts of what the company’s next earnings per share report will be. Usually, this estimate is an average of a bunch of analyst’s guesses.
So, with the Whirlpool example again, analysts are expecting the company to report earnings of $9.10 per share in their next report. This gives Whirlpool a forward P/E (often listed F P/E) of 9.80.
What’s the use of P/E (or forward P/E)? P/E is the simplest number available to compare the quality of stocks in the same sector. It puts big companies and small companies on a relatively level playing field and trims them (roughly) to the quality of their business. In general, a lower P/E ratio indicates either a bargain, a troubled company, or a very steady consistent company, while a higher P/E either means the company is a “best of breed” or it is overvalued.
Let’s look at Whirlpool again. One competitor in the same sector is Black & Decker Corporation (BDK), which has a P/E of 13.07 and a F P/E of 13.02. Whirlpool’s current P/E is 15.69, which means that currently Whirlpool has a higher P/E than Black & Decker, but interestingly, Whirlpool has a much lower forward P/E (9.80 vs. 13.02). This basically indicates that the sector is even, but that Whirlpool may be about to become a bargain, so you may want to see what Whirlpool’s been up to lately by reading news reports about them.
Generally, people who seek established companies with low P/E ratios are called value investors, because they’re looking for stocks that have a good value and show every indication of being steady earners in the short to intermediate term.