Day traders often use Price/earnings (P/E) ratios of various stocks as their primary indicators of stock performance. Your financial adviser or Yahoo finance website would tell you right away that P/E ratio is one of the easiest indicators to look at.
Price to earnings ratio in technical analysis of financial markets is computed by dividing the current stock price by earnings per share (EPS) typically over the last 4 quarters. If the price of MMM stock is 89.90 dollars with earnings per share of 5.96 then division results in 15.08. To check yourself think what will happen to P/E if price drops to 70.
However, don’t be confused by the simplicity of P/E computation because its meaningful interpretation is not simple. In a realistic example of MMM P/E above traders are charged 15 dollars for each 1 dollar of earnings that 3M stock produces. For this reason P/E ratio is also sometimes called “multiple”. The computing of P/E is not possible when corporation makes zero or negative profits.
Stock market experts argue that this interpretation may be misleading. Namely, P/E ratio that we computed above evaluates the past and not future earnings. The P/E ratio that we computed for MMM can be thought of as future earnings of the company.
Suppose that MMM equity earns 11.92 dollars instead of 5.96 in the coming year. In this case buyers of MMM stock foresee that the actual price is only 8 dollars per each 1 dollar in earnings. On the other hand, if earnings drop to 2.98 in 2012 then the multiple will be as much as 30 dollars.
On average, the price to earnings ratio takes values from 15 to 25 depending on a stock. On the other hand, the P/E will fluctuate depending on the industry and overall economic performance.
Beginners refer to P/E ratio compared to a share quote because it is scale free. Merck share that sells at 50 dollars and has a P/E of 50 is actually more costly than a $75 stock with a P/E of 20.
Notwithstanding P/E wide use it also suffers from many drawbacks. The stock price is an objective number, but EPS depends on accounting practices. Given the complexity of the modern economies even stock investment companies cannot always protect investors from accounting tricks.
Low P/E may indicate that corporation is about to get into trouble. But selling a stock with P/E of 5 without taking into account other technical indicators is also not a good idea.
Before selling such stocks experienced investors typically look at the P/E ratios of competing firms in the industry. More advanced analysts study the inflation dynamics which typically drives P/E down. The reason is that inventories tend to be understated when prices are quickly rising.
To conclude, P/E ratio is quite an accurate approximation of investor’s optimism in, say, Alcoa stock. Lower P/E compared to other firms in the industry is an early alarm indicating problems before they actually come.