Understanding P
Post on: 4 Июнь, 2015 No Comment
Be Cautious Of Using Price To Earnings Ratios To Value Individual Stocks
You can opt-out at any time.
Please refer to our privacy policy for contact information.
Price to earnings ratios can be moderately useful when looking at the stock market as a whole. However a P/E ratio can be quite misleading when looking at an individual stock.
Calculating Price to Earnings(P/E) Ratios: WIDGET
Suppose you are looking at buying WIDGET stock, symbol WDGT. Here are the facts:
- The stock is selling at $20 per share.
Comparing P/E Ratios: GZMO
You compare WDGT stock to GIZMO, symbol GZMO. Here are the facts:
In comparison to WDGT, GZMO appears to be more expensive, as you have to pay more today for the same amount of expected future earnings.
You buy WDGT.
The fallacy of P/E ratios when comparing individual stocks: WIDGET vs. GIZMO
A few months after you buy WDGT, someone files a lawsuit naming one of WDGT’s well known products as a problem. People stop buying this product, and WDGT’s earnings go down. The stock price goes down too.
GZMO, on the other hand, releases a new product that starts selling like hotcakes. GZMO’s earnings go up, and so does the stock price.
Now WDGT is at $15 per share with $1.50 of earnings per share. It now has a P/E of 10.
GZMO is selling at $15 per share with $.75 of earnings per share. It now has a P/E of 20.
You decide that GZMO is growing faster, so you sell WDGT, realize your $5 per share loss, and buy GZMO.
A year later, WDGT’s lawsuit gets dismissed. GZMO’s product, although popular, was a quick fad, and they had no more new products in the production line.
WDGT’s stock steadily climbs to $25 per share. Their earnings rise to $2.25.
GZMO’s stock drops to $9 per share. Their earnings go back to $.50.
Because of constant changes, as described in the above examples, price to earnings ratios should not be used to determine if an individual stock is appropriately valued.
