Investing: P/E Ratio basic question
The idea here is to get an idea of how to value each business and thus normalize how highly prized is each dollar that a company makes.  While some companies may make millions and others make billions, how does one put these in proper context?  One way is to consider a dollar in earnings for the company.  How does a dollar in earnings for Google compare to a dollar for Coca-cola for example?  Some companies may be valued much higher than others and this is a way to see that as share price alone can be rather misleading since some companies can have millions of shares outstanding and split the shares to keep the share price in a certain range. Thus the idea isn't that an investor is paying for a dollar of earnings but rather how is that perceived as some companies may not have earnings and yet still be traded as start-ups and other companies may be running at a loss and thus the P/E isn't even meaningful in this case. Assuming everything but the P/E is the same, the lower P/E would represent a greater value in a sense, yes.  However, earnings growth rate can account for higher P/Es for some companies as if a company is expected to grow at 40% for a few years it may have a higher P/E than a company growing earnings at 5% for example. Let's take a step back. My fictional company 'A' is a solid, old, established company. It's in consumer staples, so people buy the products in good times and bad. It has a dividend of $1/yr. Only knowing this, you have to decide how much you would be willing to pay for one share.  You might decide that $20 is fair. Why? Because that's a 5% return on your money, 1/20 = 5%, and given the current rates, you're happy for a 5% dividend. But this company doesn't give out all its earnings as a dividend. It really earns $1.50, so the P/E you are willing to pay is 20/1.5 or 13.3.  Many companies offer no dividend, but of course they still might have earnings, and the P/E is one metric that used to judge whether one wishes to buy a stock.  A high P/E implies the buyers think the stock will have future growth, and they are wiling to pay more today to hold it. A low P/E might be a sign the company is solid, but not growing, if such a thing is possible. While on the surface it might not make sense to pay more than one dollar to get just one dollar back, the key thing is that a good company's earnings are recurring each year. So, you wouldn't just be paying for the $1 dollar of earnings per share this year, but for the entire future stream of earnings per share, every year, in perpetuity -- and the earnings may grow over time too (if it remains a good company.) Your stock is a claim on a portion of the company's future. The brighter and/or more certain that future, the more investors are willing to pay for each recurring dollar of earnings. And the P/E ratio tells you, in effect, how many years it might take for your investment to earn back what you paid – assuming earnings remain the same. But you would hope the earnings would grow, too. When a company's earnings are widely expected to grow, the P/E for the stock is often higher than average. Bear in mind you don't actually receive the company's earnings, since management often decides to reinvest all or a portion of it to grow the company. Yet, many companies do pay a portion of earnings out as dividends. Dividends are money in your pocket each year.
P/E ratio is useful but limited as others have said. Another problem is that it doesn't show leverage. Two companies in the same industry could have the same P/E but be differently leveraged. In that case I would buy the company with more equity and less debt as it should be a less risky investment. To compare companies and take leverage/debt into account you could use the EV/EBIT ratio instead. Its slightly more complicated to calculate and isn't presented by as many data sources though. Enterprise Value (EV) can be said to represent the value of the company if someone would buy it today and then pay off all its (interest bearing) debt. EV is essentially calculated like this: (Market Capitalization plus cash & cash equivalents)  minus interest-bearing debt.  This is then divided by EBIT (Earnings before interest and tax) to get the ratio. One drawback of this ratio though is that it can't be used for financials since their balance sheet pretty much consists of debt and the Enterprise Value therefore doesn't tell us very much. Also, like the P/E ratio it is dependent on fresh numbers. A balance sheet is just a glimpse of the companys financial situation on ONE DAY, and this could (and probably will, although not drastically for bigger companies) change to the next day. Yep, but it you didn't answer my question (edit: I know it was phrased as a question, but I do know youre supposed to model changes in cash). When bankers calculate all three approaches, how do they compare them? From what I see, the conclusion of each approach gives us:  * Public Company Approach: Enterprise Value * Transaction Approach: Enterprise Value * Discounted Cash Flow Approach: Enterprise Value + Minimum Level of Operating Cash  Does an investment banker subtract out that minimum level of operating cash at the end of the calculation to get to a value that he can then compare? P/E is the number of years it would take for the company to earn its share price.  You take share price divided by annual earnings per share.  You can take the current reported quarterly earnings per share times 4, you can take the sum of the past four actual quarters earnings per share or you can take some projected earnings per share. It has little to do with a company's actual finances apart from the earnings per share.  It doesn't say much about the health of a company's balance sheet, and is definitely not an indicator for bankruptcy.  It's mostly a measure of the market's assumptions of the company's ability to grow earnings or maintain it's current earnings growth.   A share price of $40 trading for a P/E ratio of 10 means it will take the company 10 years to earn $40 per share, it means there's current annual earnings per share of $4.  A different company may also be earning $4 per share but trade at 100 times earnings for a share price of $400.  By this measure alone neither company is more or less healthy than the other.  One just commands more faith in the future growth from the market. To circle back to your question regarding a negative P/E, a negative P/E ratio means the company is reporting negative earnings (running at a loss).  Again, this may or may not indicate an imminent bankruptcy.  Increasing balance sheet debt with decreasing revenue and or earnings and or balance sheet assets will be a better way to assess bankruptcy risk. It's safe to say that for mature companies, with profits that have been steady, and steadily growing, that a multiple of earnings can come into play. It's not identical between companies or even industries, but for consumer staples, for instance, you'll see a clustering around a certain P/E.  On the other hand, there are companies like FaceBook, 18 months ago, trading at 20, now at 70 with a 110 P/E. Did the guys valuing the stock simply get it wrong then or is it wrong now?  Contrast this with KO (Coca-cola) a 20 P/E and 3.2% dividend, PG (Proctor and Gamble) 21 P/E, 3% dividend.  Funny though, a $1M valuation for $50K in profit may be Shark ridiculous, but a $1B valuation on a $50M company with great prospects, i.e. a pipeline of new products in growing markets, is a steal.  Disclosure I have no positions in the mentioned stocks. The intrinsic value of a company is based on their profits year on year along with their expect future growth. A company may be posting losses, but if the market determines there's any chance they will turn a profit one day, or be a takeover target, it assigns value to those shares. In normal times, you'll observe a certain P/E range. Price to earning ratio is a simple way to say the I will pay X$ for a dollar's worth of earnings. A company that's in a flat market and not growing may command a P/E of only 10. Another company that's expanding their products and increasing market share may see a 20 P/E. Both P/Es are right for the type of company involved. That's pretty typical for introductory problems.  It's leading you into an NPV question.  They're keeping the cash flows the same to illustrate the time value of money to show you that even though the free cash flow is the same in year 1 and year 4 or whatever when you discount it to present value today's stream is worth more than tomorrow's "Check your math... ""two stocks, both with a P/E of 2 trading at $40 per share lets say, and one has an EPS of 5 whereas the other has an EPS of 10 is the latter a better purchase?"" If a stock has P/E of 2 and  price of $40 it has an EPS of $20. Not $10. Not $5." "For free, 5 years is somewhat available, and 10 years is available to a limited extent on money.msn.com. Some are calculated for you. Gurufocus is also a treasure trove of value statistics that do in fact reach back 10 years. From the Gurufocus site, the historical P/E can be calculated by dividing their figure for ""Earnings per Share"" by the share price at the time.  It looks like their EPS figure is split adjusted, so you'll have to use the split adjusted share price. ""Free cash"", defined in the comments as money held at the end of the year, can be found on the balance sheet as ""Cash, Cash Equivalents, Marketable Securities""; however, the more common term is ""free cash flow"", and its growth rate can be found at the top of the gurufocus financials page." Try to find the P/E ratio of the Company and then Multiply it with last E.P.S, this calculation gives the Fundamental Value of the share, anything higher than this Value is not acceptable and Vice versa. Ah, pardon me, so it's not *either* 10x return or zero, but also includes points in between there?  Is it path dependent? Do you have any history on the asset?  The usual crutches for dealing with unknown probabilities are using risk neutrality or arbitrage pricing, but if the market is inefficient then that will be an estimation at best. In the equity markets, the P/E is usually somewhere around 15.  The P/E can be viewed as the inverse of the rate of a perpetuity. Since the average is 15, and the E/P of that would be 6.7%, r should be 6.7% on average. If your business is growing, the growth rate can be incorporated like so: As you can see, a high g would make the price negative, in essence the seller should actually pay someone to take the business, but in reality, r is determined from the p and an estimated g. For a business of any growth rate, it's best to compare the multiple to the market, so for the average business in the market with your business's growth rate and industry, that P/E would be best applied to your company's income. "P/E alone would not work very well. See for example http://www.hussmanfunds.com/html/peak2pk.htm and http://www.hussmanfunds.com/rsi/profitmargins.htm (in short, P/E is affected too much by cyclical changes in profit margins, or you might say: booms inflate the E beyond sustainable levels, thus making the P/E look more favorable than it is). Here's a random blog post that points to Schiller's normalized earnings measure: http://seekingalpha.com/article/247257-s-p-500-is-expensive-using-normalized-earnings I think even Price to Sales is supposed to work better than P/E for predicting 10-year returns on a broad index, because it effectively normalizes the margins. (Normalized valuation explains the variance in 10-year returns better than the variance in 1-year returns, I think I've read; you can't rely on things ""reverting to mean"" in only 1 year.) Another issue with P/E is that E is more subject to weird accounting effects than for example revenues. For example whether stock compensation is expensed or one-time write-offs are included or whatever can mean you end up with an economically strange earnings number. btw, a simple way to do what you describe here would be to put a chunk of money into funds that vary equity exposure. For example John Hussman's fund has an elaborate model that he uses to decide when to hedge. Say you invest 40% bonds, 40% stocks, and 20% in Hussman Strategic Growth. When Hussman fully hedges his fund, you would effectively have 40% in stocks; and when he fully unhedges it, you would have 60% in stocks. This isn't quite the whole story; he also tries to pick up some gains through stock picking, so when fully hedged the fund isn't quite equivalent to cash, more like a market-neutral fund. (For Hussman Funds in particular, he's considered stocks to be overvalued for most of the last 15 years, and the fund is almost always fully hedged, so you'd want to be comfortable with that.) There are other funds out there doing similar stuff. There are certainly funds that vary equity exposure though most not as dramatically as the Hussman fund. Some possibilities might be PIMCO All-Asset All-Authority, PIMCO Multi-Asset, perhaps. Or just some value-oriented funds with willingness to deviate from benchmarks. Definitely read the prospectus on all these and research other options, I just thought it would be helpful to mention a couple of specific examples. If you wanted to stick to managing ETFs yourself, Morningstar's premium service has an interesting feature where they take the by-hand bottom-up analysis of all the stocks in an ETF, and use that to calculate an over- or under-valuation ratio for the ETF. I don't know if the Morningstar bottom-up stuff necessarily works; I'm sure they make the ""pro"" case on their site. On the ""con"" side, in the financial crisis bubble bursting, they cut their valuation on many companies and they had a high valuation on a lot of the financials that blew up. While I haven't run any stats and don't have the data, in several specific cases it looked like their bottom-up analysis ended up assuming too-high profit margins would continue. Broad-brush normalized valuation measures avoided that mistake by ignoring the details of all the individual companies and assuming the whole index had to revert to mean. If you're rich, I think you can hire GMO to do a varied-equity-exposure strategy for you (http://www.gmo.com/America/).  You could also look at the ""fundamental indexing"" ETFs that weight by dividends or P/E or other measures of value, rather than by market cap. The bottom line is, there are lots of ways to do tactical asset allocation. It seems complex enough that I'm not sure it's something you'd want to manage yourself. There are also a lot of managers doing this that I personally am not comfortable with because they don't seem to have a discipline or method that they explain well enough, or they don't seem to do enough backtesting and math, or they rely on macroeconomic forecasts that probably aren't reliable, or whatever. All of these tactical allocation strategies are flavors of active management. I'm most comfortable with active management when it has a fairly objective, testable, and logical discipline to it, such as Graham&Buffett style value investing, Hussman's statistical methods, or whatever it is.  Many people will argue that all active management is bad and there's no way to distinguish among any of it. I am not in that camp, but I do think a lot of active managers are bad, and that it's pretty hard to distinguish among them, and I think active management is more likely to help with risk control than it is to help with beating the market. Still you should know (and probably already do know, but I'll note for other readers) that there's a strong argument smart people make that you're best off avoiding this whole line of tactical-allocation thinking and just sticking to the pure cap-based index funds." The PE ratio stands for the Price-Earnings ratio. The price-earnings ratio is a straightforward formula: Share Price divided by earnings per share. Earnings per share is calculated by dividing the pre-tax profit for the company by the number of shares in issue. The PE ratio is seen by some as a measure of future growth of a company. As a general rule, the higher the PE, the faster the market believes a company will grow. This question is answered on our DividendMax website: http://www.dividendmax.co.uk/help/investor-glossary/what-is-the-pe-ratio Cheers Usually their PE ratio will just be listed as 0 or blank.  Though I've always wondered why they don't just list the negative PE as from a straight math standpoint it makes sense. PE while it can be a useful barometer for a company, but certainly does not tell you everything.  A company could have negative earnings for a lot of reasons, some good and some bad.  The company could just be a bad company and could be losing money hand over fist, or the company could have had a one time occurrence such as a big acquisition or some other event that just affected this years earnings, or they could be an awesome high growth company that is heavily investing for their future and forgoing locking in profits now for much bigger profits in the future. Generally IPO company's fall into that last category as they are going public usually because they want an influx of cash that they are going to use to grow the company much more rapidly.  So they are likely already taking all incoming $$ and taking on debt to grow the company and have exceeded all of those options and that's when they turn to the stock market for the additional influx of cash, so it is very common for these companies not to have earnings.   Now you just have to decide if that company is investing that money wisely and will in the future translate to actual earnings. I would suggest at least getting a personal card that you only use for business expenses, even if you don't opt for a business card.  It makes it very clear that expenses on that card are business expenses, and is just more professional.  The same goes for a checking account, if you have one of those.  It makes it easier to defend if you are ever audited, and if you use an accountant or tax preparer.