Monday, April 10, 2006

Blog of the Week: The Average Joe Investor

Back to the Basics: Price to Earnings Multiple (P/E)

This is a topic that I covered somewhat in a past post (Jumping on Opportunities), but this is a concept that really merits its own article. The price to earnings multiple, aka P/E, price to earnings ratio or just earnings multiple is easily the most used gauge of a stock's valuation in the world of investing, so having a good understaning why and how it's used is pretty crucial.

As an example here, let's take a look at two stocks, Goldman Sachs Group Inc (ticker: GS) and JDS Uniphase (Nasdaq: JDSU). Goldman Sachs has a per share price of about $161 while JDSU trades at just under $4 per share. So does this mean that Goldman Sachs stock is worth 40x more than JDSU? Well, the simple answer is no. Now here's the reason why: people buy stocks to make money and they make money when the stock's price goes up. A primary reason that the price of a stock goes up is that either the company is making a lot of money (profit) or people have expectations that the company will soon be making more money.

Now, of the money that the company makes, each shareholder theoretically gets to take part in a portion of those profits equal to the percentage ownership they have. So if a company makes $10 in profit and has 10 shareholders, each shareholder would get $1 of those profits. This is called the earnings per share (better known as EPS). Since shareholders want to maximize the return (profit) that they get in relation to how much they had to invest in the company in the first place, they use the price to...

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