Ive been asked many times what the P/E ratio of a company represents. Ive discovered that its best understood when it relates back to ones income after expenses. I honestly believe most terms within the investment world are made overly complicated so professionals can keep their jobs. If a professional cant explain terms in a simplistic manner, then they really just dont understand it themselves in my opinion. Better yet, if your professional adviser or money manager cant explain it to you. Hes either incompetent or possibly pushing a product that is too complex for you to invest in.
So what is a P/E ratio?
The P/E ratio is simply a ratio of two numbers, the top number P is the price the stock is currently selling for in the market. The bottom number E is the earnings. I find that most people have no problem with the top number, because it constantly fluctuates on a daily basis. The earnings is where some of my fellow investors become confused.
What are earnings?
Earnings are the net profit for the year or a particular quarter. In most cases they take the earnings data for the prior 12 months, hence the term trailing P/E. The earnings is basically everything left from revenues after all the companies bills and taxes are paid. Its really no different than how much you have left over from your check after paying all your bills. For example lets say you bring $3000 home every month and your expenses are $2000, you now have $1000 left. The extra money can either be put in your savings or spent as you please. This would essentially be the earnings for a company.
Umm..So how does that large number divide into a share?
Im way ahead of you. If you research a company, youll notice that it list the number of shares outstanding. If you divide the net income, your money left after bills, by that number of shares youre left with the earnings per share (EPS). Make Sense?
So where can I find this earnings Number?
Thats digging a little deeper than intended for this particular article, but the earnings are located on the Income Statement of the companys quarterly and/or annual report provided to the SEC on a regular basis by law. Their usually located on the website somewhere or filed away on the Security Exchange Commission (SEC ) website. Al though Ill have to save that topic for another time.
Next time you search for your stock of interest I hope this helps. The P/E ratio is so closely followed, because of the simplicity of its calculations. The higher the number, the more expensive the stock is, because the selling price is a multiple of Net profit. Much more information will be provided soon. I know investing in equities can be a daunting task, but every thing that is complicated can be simplified . It only gets complex once you want to dive deep down in the details. So next time youre researching a company, think of the P/E as Price divided by earnings.