Wednesday, July 8, 2015

What Do P/E Ratios Really Mean?

Taken from p. 143 of Active Value Investing, the classic book from Vitaliy N. Katsenelson.

P/E (price per earning) refers to the amount of money stock investors are willing to pay for the stock as reflected in its stock price. First, determine how much the company is earning per share. Then check the stock price. Divide the current stock price by the earnings per share number. You have the P/E ratio!

So is a high P/E a good or bad sign? Depends.

A new growth stock will typically show much higher P/E ratios than an established company. Once a company stops growing rapidly, the P/E ratio will actually decline. 

Katsenelson quotes the legendary Benjamin Graham as giving a P/E figure of around 8 as about right for a company with solid fundamentals but low growth.

Katsenelson includes a cool chart on p.143 that shows appropriate levels of P/E in relation to expected levels of growth.

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