What is a P/E Ratio and Why Does it Matter?

You have probably heard financial analysts advise that a stock is overbought or oversold, or that it has a high or low valuation. But what exactly does that mean? The concept underlying those assessments is the price-to-earnings ratio (P/E), and understanding it can provide insight into whether a stock is being traded at a price that is proportionate to its worth. The P/E ratio is the baseline of all stock analysis.

Simply put, the P/E ratio quantifies the relationship between two things: how much a company is earning on a per-share basis, and how much investors are willing to pay for each dollar of those earnings. The ratio is easy to calculate: you take the current price of a stock and divide it by the earnings per share (EPS) over the last four quarters. For instance, Coca-Cola (KO) earned $1.60 per share in the 2014 fiscal year and the stock was recently trading at about $41.52. Dividing the latter by the former, we see that KO was trading at a P/E of just under 26.

Is that high or low? The answer depends on who you are comparing it against. Often P/E ratios are compared within a market sector, such as consumer staples. Other times they are compared against the average of an index such as the S&P 500.

One thing to understand right off the bat is that the more a company is expected to grow its earnings in the future, the higher its P/E ratio will be. That is why Facebook (FB) has a P/E ratio of nearly 80 while Exxon Mobil (XOM) has a P/E ratio of only 13. Some might argue that Facebook shares do not deserve a valuation that is 6 times higher than Exxon Mobil, but the market sends a message with this rich valuation that it believes Facebook will grow its earnings sharply in the future.

Historical P/E Ratios. It is not just individual stocks that have P/E ratios. Even the S&P 500, one of the broadest market indexes, has a P/E ratio of its own. That P/E compares the price of the index to the total earnings of the 500 companies within it, and it was recently close to 21. Interestingly, this number can be extremely volatile and varies widely with both macro factors affecting the economy and micro factors that affect the individual companies within the index.

Over the trailing 140 years of its history, the average P/E of the S&P is about 16, with the most frequent P/E levels ranging from 10 to 20. And over the past 5 years, as our stock indexes have been steadily rising, P/E ratios have continued to creep higher. That leads some people to think that stock prices are overvalued, while others believe the market is expressing heightened expectations for future earnings growth.

What it Means for Your Investment Strategy. Understanding the P/E ratio can inform your decisions about what to include and exclude from your portfolio. For example, knowing that a given stock trades at nearly 80 times its trailing earnings might help you determine whether you want to own that stock. Perhaps you believe strongly in the company and are willing to buy the stock at that valuation because you believe that at some point in the future, the company will earn 10 times more than it does today.

On the other hand, evaluating a P/E ratio may help you realize that you prefer to buy the value side of the market, which typically consists of stocks and indexes with more modest P/E ratios. Warren Buffet is one of the most famous value-oriented investors, and is known for buying stocks with margins of safety, often in the form of low P/E ratios.

Of course, the P/E ratio is only one factor of many that an investor may consider when building an investment portfolio. The P/E ratio is easy to identify and widely discussed, so it is a good number to understand. At the very least, it can provide you with a jumping-off point for analyzing a stock, sector, or broad market index.

 

Discussion

Answer the questions using the following expressions:

It’s clear from… that….

I can say that….

Speaking about ….

I think / suppose / believe / assume / presume ….

Judging by … I come to the conclusion that ….

1. What helps to understand whether a stock is being traded at an appropriate price?

2. Why is P/E ratio called a baseline of all stock analysis?

3. What must one do to calculate the P/E ratio?

4. What will the high P/E ratio of a company depend on?

5. Has the average historical level of P/E ratio been ranging high?

6. What stocks is it better to buy?

Reading 6

Stock Market Crash

A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles.

Stock market crashes are social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives more market participants to sell. Generally speaking, crashes usually occur under the following conditions: a prolonged period of rising stock prices and excessive economic optimism, a market where P/E ratios exceed long-term averages, and extensive use of margin debt and leverage by market participants.

Crashes are often distinguished from bear markets by panic selling and abrupt, dramatic price declines. Bear markets are periods of declining stock market prices that are measured in months or years. While crashes are often associated with bear markets, they do not necessarily go hand in hand. The crash of 1987, for example, did not lead to a bear market. Likewise, the Japanese Nikkei bear market of the 1990s occurred over several years without any notable crashes.

The market moves in cycles, and a crash at some point is inevitable. The key question, then, is not whether there will be a stock market crash or not – it is when. An individual who is investing in stock market should book the profit timely without getting greedy for more money because markets have become so volatile and business cycle is changing tremendously due to globalization. To be on the safer side and learning from historical crashes one should invest in different stocks and book profits on time.

 

Discussion.