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What is P/E, And Can You Trust It To Know Company’s Value?

Photo courtesy of Simon Cunningham via Flickr

Want to know how much a company is worth? It’s not always easy to tell. One aspect that investors look at to get a sense of a publicly held company’s value is their price to earnings ratio, also called P/E.

What is P/E? Essentially, it’s a valuation of a company’s share price (or stock value) compared to its pre-share earnings — a measurement of how much investors pay for a share of their profit.

In other words, P/E allows comparison and analysis of the current stock price of a company with the their actual earnings for the past 12 months, or their estimated future earnings, called forward P/E. These factors, for a number of reasons, are sometimes at odds.

How does it work?

P/E is divided by any given company’s earnings per share (EPS) to determine the P/E ratio.

For example, if a stock trades at $40 per share with an EPS of $2, that’s a P/E of 20, expressed by dividing $40 by $2. P/E averages vary over time and by sector– as of January 2014, the total market average was 52.

If a company has high P/E, that means their stocks are currently worth per share over the amount the company is earning. This could mean a number of things — the stock might be overpriced, or the market may be extremely confident about its future growth.

If a company has low P/E, that may mean the market has little confidence in the company’s growth, or that their potential has yet to be seen, making it a value stock and a potential diamond in the rough. (If a company is losing money, they have no P/E.)

Dubious P/Es

Most agree that it’s unwise to judge a company by their P/E alone, as there are many factors that can help determine a company’s worth, such as their business model, growth rate, and management.

Still, some P/Es are notable for being extremely high, low, or nonexistent — especially with tech and Internet companies–which are in constant flux and have potential that is difficult to measure.

It’s wise for investors to be wary of P/Es that are very high or very low, especially during economic booms. It is also best to compare P/E within specific industries to ensure accuracy.

Why does it matter?

You’ll see P/E in the news, especially regarding highly valued companies like Facebook, which reported record high earnings In July 2014 after a successful quarter.

Companies like Amazon, Netflix, and LinkedIn have extremely high P/Es, indicative of overvalue. Twitter, Groupon, and Yelp are examples of companies that have no P/E whatsoever because they aren’t turning profit, which some also consider a sign of overvalue.

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Jennifer Markert