Trillionaire Term of the Day - January 7, 2009

P/E Ratio

The P/E ratio is one the single important numbers that investors use to judge the value of company's stock price. The number is actually quite simple: it is the Price of the stock divided by EPS.

Let me use NICE-Systems Limited (NICE), a technology company, as an example that shows how P/E can be used to judge a stock's value. NICE is currently trading at about 23.30 and its EPS is .47. The P/E = (23.30) / (.47). So P/E= 49.89.

A large P/E ratio can be interpreted to mean that the company is highly valued by its shareholders. Think about it logically. A company reports a low earnings per share when compared to the price of a stock. Therefore, the buyers of stock are paying a higher price because they believe the company is worth more. But be forewarned, a high P/E does not mean that you should buy stock in a company. It may, in fact, indicate the opposite!

You have to judge what you think the value of a company is versus what other people think the value is (measured by the P/E). To give you some perspective, the P/E of 49.89 that NICE currently holds is high. If read more about the company, you’ll know that it has recently expanded its business internationally and is steadily growing. Therefore, we might assume that investors appreciate this growth and are paying for it in the stock price. But should you buy the stock? A P/E of 49.89 is very high, and this indicates that investors value the company very highly. So for NICE to be a profitable buy, the value of the company must be EVEN HIGHER than those investors think. The odds of this are less likely with a stock that already has a high P/E ratio.

On the other hand, if you highly value a company, but the P/E ratio is low, you would take this as a very strong sign to buy. This would indicate that the company is undervalued by investors and, if you’re right in your judgment, that it should do well in the future.

Having a good understanding of the Price/EPS ratio and applying it to your analysis of companies will greatly help your chances at making big profits in the stock market.