price to earnings ratio
The Price to Earnings (P/E) ratio is a popular method of determining whether a stock is cheap or not. This metric is used generally to compare stocks in the same industry or sector. For this example, we will use the company Microsoft. The P/E ratio calculation is rather simple, all we have to do is take the current stock price, which for Microsoft is 40.21 and divide it by the annual earnings per share, which happens to be 2.67. Once we divide those numbers we get 15.04 rounded. Now, as we look at the actual P/E ratio we see that it is 15.03, and that is because the stock was falling slightly after hours, but we won't worry about that. Now, let's say that for whatever reason Microsoft is a really stable company, let's imagine for a second that this company's earnings doesn't move at all when people predict forward earnings. An interesting thing you can do here is, do the inverse of this ratio, and by that you would be doing the earnings to price ratio, something that is very overlooked. Once we do the inverse, we come up with 0.66, or 6.6%. This means that if Microsoft has the exact same EPS next year, the equity will grow by 6.6%, meaning the same equity increase for any stockholder. That's very interesting, and something that you might wanna incorporate in when you are evaluating stocks. Getting back on track with the P/E ratio, you are probably wondering, if the P/E ratio of Microsoft is 15.03, is it good or bad? Well, again it depends on the company, but a general rule of thumb is that a really good P/E ratio will be under 10, while, anything above 25-30 is something to be wary about. In general, the P/E ratio of Microsoft can be determined as decent. Another thing to remember, is that the lower your P/E ratio, the higher your earnings to price, which helps you maximize your profit as an investor, which is always your goal when you invest in any stock.
Now, what we are gonna do is compare two stocks in the same sector, and try and use the P/E ratio of these two companies to compare the stocks. We will use Cenovus Energy, and Crescent Point Energy in this example. These companies are both in the energy sector, so the P/E ratio will really be able to help us out in this example, in deciding which stock we might wanna buy. Now, you might think why not buy both? Well, the thing is you want your portfolio to have diversification, so it wouldn't be the most ideal scenario to have two stocks of similar stature in your portfolio. So, the first thing we wanna do is see the share price for these companies, for Crescent Point this is currently 44.04, and for Cenovus this is 29.09. As we compare first quarter 2014 earnings we see that the EPS for Cenovus is 0.89, and for Crescent Point, their EPS is 0.41. From here, it is quite obvious that Cenovus has the better EPS, but again we need to remind ourselves that, this may just be because Cenovus is a bigger corporation. Anyway, with these numbers we can now evaluate the P/E ratio for these stocks. As we remember from before, calculating P/E ratio is just stock price divided by the EPS. Okay, for Cenovus, 29.09 divided by 0.89, is 32.71, and as we look at the actual PE we see that it is the almost exact same at 32.69. Now we do the same thing for Crescent Point, we divide 40.54 by 0.41 and we get a P/E ratio of 97.9, and the exact number is 97.92. Now, this is an insanely high P/E ratio. Remember, we talked before about how a PE of over 25 should be something that we proceed with caution. Now, a PE of 97.92 for Crescent Point raises alarm bells right away, as the stock is almost 15 dollars more expensive than Cenovus and has less than half of the earnings per share of Cenovus. You might be thinking why on earth would someone want to buy this stock, and the simple reason may be high, continuing growth, which would eventually lower the P/E ratio. We know we have the P/E ratio here, but you should be asking right away, is this the P/E ratio for the last 12 months, is this the forward PE, what earnings are you using to calculate this number. For us, we are using the trailing twelve months, earnings to calculate the PE. However, remember that you P/E isn't the only metric used to evaluate a stock. You should always also consider forward earnings estimates, because maybe the company is expected to grow so much, that the PE will be lowered significantly.
Now, what we are gonna do is compare two stocks in the same sector, and try and use the P/E ratio of these two companies to compare the stocks. We will use Cenovus Energy, and Crescent Point Energy in this example. These companies are both in the energy sector, so the P/E ratio will really be able to help us out in this example, in deciding which stock we might wanna buy. Now, you might think why not buy both? Well, the thing is you want your portfolio to have diversification, so it wouldn't be the most ideal scenario to have two stocks of similar stature in your portfolio. So, the first thing we wanna do is see the share price for these companies, for Crescent Point this is currently 44.04, and for Cenovus this is 29.09. As we compare first quarter 2014 earnings we see that the EPS for Cenovus is 0.89, and for Crescent Point, their EPS is 0.41. From here, it is quite obvious that Cenovus has the better EPS, but again we need to remind ourselves that, this may just be because Cenovus is a bigger corporation. Anyway, with these numbers we can now evaluate the P/E ratio for these stocks. As we remember from before, calculating P/E ratio is just stock price divided by the EPS. Okay, for Cenovus, 29.09 divided by 0.89, is 32.71, and as we look at the actual PE we see that it is the almost exact same at 32.69. Now we do the same thing for Crescent Point, we divide 40.54 by 0.41 and we get a P/E ratio of 97.9, and the exact number is 97.92. Now, this is an insanely high P/E ratio. Remember, we talked before about how a PE of over 25 should be something that we proceed with caution. Now, a PE of 97.92 for Crescent Point raises alarm bells right away, as the stock is almost 15 dollars more expensive than Cenovus and has less than half of the earnings per share of Cenovus. You might be thinking why on earth would someone want to buy this stock, and the simple reason may be high, continuing growth, which would eventually lower the P/E ratio. We know we have the P/E ratio here, but you should be asking right away, is this the P/E ratio for the last 12 months, is this the forward PE, what earnings are you using to calculate this number. For us, we are using the trailing twelve months, earnings to calculate the PE. However, remember that you P/E isn't the only metric used to evaluate a stock. You should always also consider forward earnings estimates, because maybe the company is expected to grow so much, that the PE will be lowered significantly.