In finance, PE stands for price-to-earnings ratio, and tells you whether a stock, a stock index, or a mutual find consisting of stocks is selling at a reasonable price. The PE ratio compares the price of the stock to the profits of the corporation. When calculating the PE ratio for a collection of stocks that make up a mutual fund or a stock index, financial analysts use a weighted average. Understanding PE ratios will make you a better investor.
Earning Per Share
Along with the PE ratio, you will also frequently hear a figure called EPS, which stands for earnings per share. A financial analyst must calculate EPS to come up with the PE ratio. Similarly, an investor must grasp the meaning and significance of EPS to understand PE. EPS equals the corporation's net profits for a given period divided by the number of common shares outstanding. In simpler terms, EPS equals how much the company earned per each outstanding share. If the EPS equals $1.50 and you own 100 shares in the company, your share of the company's total profits equals $1.50 times 100, or $150. If the company also has preferred shares, which is a special, privileged share class, EPS calculation becomes a little more complex.
The PE ratio for a stock equals the most recent price for the stock divided by the EPS. If the prevailing market price for the share is $15 and the EPS is $1.50, the PE ratio equals $15 divided by $1.50, or 10. Such a stock is said to be trading at 10 times earnings. This means that you are paying 10 times as much for the stock as the company is earning per stock. If the corporation sustains the present ratios, it will earn sufficient money, per share, to equal your purchase price of the share in exactly 10 years.
Mutual Fund PE
The PE of a mutual fund equals the weighted average PE of all the stocks that make up the mutual fund. The weights of the stocks when calculating the average is determined by their market values. If a fund is holding $200,000 worth of stock A and $300,000 worth of stock B, for example, the total holdings equal $500,000. In this example, 40 percent of this total is held in stock A and 60 percent in stock B. If the PE ratios of the stocks are 10 and 12, respectively, the fund's PE ratio equals 40 percent of 10 plus 60 percent of 12. The fund's PE is therefore (0.410) + (0.612) = 11.2
When investing in mutual funds, an investor generally looks for a low PE ratio. This means that the average price of the stock in the fund, compared to the earnings of the companies whose stocks are in the fund, is relatively low. The expectation is that the companies will quickly earn enough to make up for the purchase price of the stocks. Investing in stocks with high PE ratios is a strategy that can also pay off. Some mutual funds focus on companies with high prices and resulting high PE ratios. Such corporations are usually performing well in their industries, and their stock prices are therefore relatively high. During hard economic times, these strong companies can weather the storm when many smaller competitors fail. The PE ratio of a fund should therefore be evaluated within the broader context of its strategy.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.