David Cook, CFP® defines what a P/E (Price to Earnings) Ratio is. The ratio is the market value per share divided by earnings per share. Understand the other metrics to evaluate and know the difference of sectors that the P/E ratios go against.
Transcription:
“Hi, I’m David Cook, CERTIFIED FINANCIAL PLANNER™ with Pure Financial Advisors, and this is your Question of the Week. What is a P/E ratio? Price to earnings ratio. It is an economic metric that is used as somewhat of a comparable when evaluating a stock. What the ratio is–it’s the market value per share divided by the earnings per share.
Some industries are going to have a higher P/E ratio, such as the technology industry. That’s where you’ll see a little bit higher expected earnings in the future. Some industries like the utilities sector have a lower P/E ratio, and it’s really hard to compare a stock in the technology sector versus a utility stock because it’s kind of comparing apples to oranges. Apple for instance has a 17.3 P/E ratio right now, and so does Microsoft–two stocks in the same industry. The utility sector is going to have about a seven P/E ratio currently right now, so you really can’t compare the two. But again, it doesn’t mean any one is going to be better, it should probably be more inclusive in your portfolio.
When using the P/E ratio, it’s important to compare apples to apples. Again, you don’t want to compare a technology stock to a utilities stock, because they’re going to have much different P/E ratios for different reasons. A technology stock may not have a lot of earnings right now but may have a lot of future growth. Facebook, for instance, has a P/E ratio of approximately 75 right now. A utility stock may have a P/E ratio of six or seven but it pays a high dividend–but not much growth in the future.
Again, the P/E ratio is not the whole story. There are other things that you need to consider, other metrics that you have to evaluate. You also have to know the difference of sectors and the P/E ratios that go against. Is it over-valued against its peers or is it under-valued against its peers? Warren buffet us a big value investor. He’s probably looking for good discounts and he looks at the P/E ratio probably to find value.
Again, when you’re evaluating, P/E ratios are a great place to start, but it’s not the only thing you need to look at. That is your Question of the Week.”
