Summer school: P/E ratio

Marketplace Staff Jul 20, 2007
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Summer school: P/E ratio

Marketplace Staff Jul 20, 2007
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COPY

TESS VIGELAND: Ah yes, that may be true. But here at Marketplace Money, summer school’s in session.

This week, we’re exploring something you might think relates to junior-high gym class. It’s called the P/E ratio. You’ll hear the term a lot this time of year as companies announce their quarterly earnings. At the blackboard this week, economist Chris Low.

CHRIS LOW: It is a ratio of the price of a stock to the earnings per share in that stock. It is the favorite measure of value in the stock market. You’ll hear people talk about P/E ratios for individual stocks, and also for stock indexes, like the S & P 500, for instance.

It’s important and it’s a favorite becuase it gives you a consistent standard of value that helps investors decide if they’re paying enough or too much, or even not enough. Maybe a stock is undervalued. There are some stocks where a higher P/E ratio is justified, but it means you’re taking significant risk, because what you’re doing is your’e betting that earnings growth is going to accelerate fast enough that that P/E will look normal soon. Of course, another way a P/E could go from very high to normal would be if the price dropped. So if someone’s buying stock into a high P/E company, there better be a pretty good reason to expect higher earnings in the future.

Imagine Wiley Coyote’s favorite company, Acme Corporation, just released earnings at $5 a share. And the share price is $20 right now. So the P/E would be the price divided by earnings, or 20 divided by 5, which is 4. The lower the P/E, the better, because what that tells you is you’re getting more earnings for your investment dollar.

So Wiley Coyote’s doing pretty well, assuming he’s buying the shares. Of course, if he’s buying the products, we all know how that turns out.

VIGELAND: Our teacher this week was Chris Low. He’s the chief economist with FTN Financial in New York. Next week, how gross is Gross Domestic Product?

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