It’s the P/E ratio, not the EP ratio How the P/E Ratio can and can't help you By Mo2

The P/E Ratio is a widely used ratio among stock investors. You often hear on business news, “Mo2 Shares are trading at 400 times earnings.” That essentially is the P/E ratio, I’ll get into a little more detail and what I really think about this ratio in a little bit. Before I do that, I have to tell you two things! There is no such thing as a Mo2 stock (not yet) and if a stock is trading at 400 times earnings then it has issues. Have I confused you yet? I hope so, that’s what I’m here for.

What does the P/E Ratio Stand For?
First off you read it as the Price/Earnings Ratio. Therefore, just as the name suggests you divide the price of the stock by the earnings of that stock. Here’s what it looks like:

Market Price of Stock
Earnings per stock

So how exactly do you use this wonderful number? Some think it’s the holy grail of investing. Buy a low P/E ratio stock and you’re bound to be successful! While, I wouldn’t count out the P/E ratio as vital part of a trading system, you should never judge a stock by solely its P/E ratio.

Relatively speaking…
The P/E ratio is a relative number. You have to look at the industry of the stock as a whole. If the Mining industry average is ten times earnings or has a P/E ratio of 10, and Minelover shares are trading at 40 times earnings you might want to investigate why. Obviously, investors are willing to pay a higher amount for Minelover shares compared to other industry competitors for a reason.

It might be for a variety of reasons. Minelover might be a takeover target or might have had unbelievable news that made the stock take off. Or it might be artificially inflated for unknown reasons such as investors falling in love with the name “Minelover.” Before you laugh that comment off, it often does happen that some names on stock markets have higher stock prices just because they have a likeable (or famous) name!

Downfalls
First, not everyone calculates their earnings the same way. Of course, most companies should be reporting their earnings properly but how they go about reporting them may not be exactly the same. Most likely they will abide to the GAAP (Generally Accepted Accounting Principles) or whatever is equivalent but obviously not everyone has the same accountant and no matter what anyone says there will always be discrepancies.

A P/E ratio maybe inflated because of inflation, popularity, market momentum, or because the sun started moving in the wrong direction. Who knows, but that should make you think twice before buying a stock by simple looking at the P/E ratio only. Just like the Payout Ratio (look at Payout Ratio article here) these figures cannot be used on their own to determine your investments. If you’re too lazy to look at everything then just stick your money into mutual *shudder* funds.

 

Mo2 Thinks
P/E ratios are great, they give you a nice figure to compare with other stocks. Just in case you didn’t know, stock prices mean absolutely nothing when it comes to investing. If you’re looking at a $100 stock and saying, “Gee that’s pricy. I should just buy the other financial $50 stock instead because it’s cheaper.” Ok, I’m talking more about market capitalization than the P/E ratio and that’s another article but it also has to do with P/E ratios. Although you shouldn’t be looking only at P/E ratios it gives you somewhat of a better view than the stock price for obvious reasons.

P/E ratios can be used as a starting point to give you an idea as to where a stock stands among its competitors and the market as a whole. You need to determine whether if it is a growth company or something else. Growth companies will tend to have higher P/E ratios because they are expected to earn more because they are “growing.” Yes, that’s really cheesy and I’ll probably have to go into more detail in another article. You didn’t expect me to write 15,000 words tonight did you? Hope not…

As with everything do your research and try to get a feel for what the market is doing on a whole. Before you even look at P/E ratios you should have a decent idea as to what the economy is doing as well. What about home prices? How about same-stores sales of Walmart? You might be surprised what these two figures alone can tell you. Don’t hold me on that, I’m not your financial/investment advisor. If you want me to be, I guess I’ll be seeing a 6 digit (numbers after decimal do not count) US dollar money order in my mailbox soon.

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Dollar Cost Averaging Investing

If you would like to comment on this article or anything on this website, please feel free to e-mail Mo2. He can be reached at Mo2@Mo2Thinks.com. Thank you for visiting!