What is the Price Earnings Ratio?

A price earnings ratio, or "P/E" for short, is a commonly used way to simplistically value a company (determine what a company's stock should be worth). It is simply a company's stock price divided by a company's earnings per share.

P/E divided by EPS

The P/E ratio measures the level of confidence investors have in a company. Investors are often willing to pay more for stocks with a high P/E ratio because they expect the company to have high future returns or they believe the company is growing faster than average.

P/E ratios can be used to compare against other companies.

Higher P/E ratio's are often associated with "growth stocks", or companies that are growing faster than average. The reason why some companies have a high P/E is because investors believe that the company's earnings will be higher in the future. P/E ratios cannot be applied to companies without any earnings. So if you have “n/a” for P/E this company has not had any earnings – not a good choice.

The P/E ratio is a measure of how much you pay for a dollar's worth of earnings. Think about this, and you'll see that it is a neat way to compare stocks. As you can see, the P/E for Apple Inc. is 9.2. This means that if you buy AAPL at the price shown, you would be paying $9.20 for a dollar's worth of earnings. You'll find the P/E for Google is 20.3. Do you wonder why investors would pay more for $1s worth of Google than they would for Apple? Because they value Google’s growth prospects and ability to generate a return on its investments more highly than Apple's.

What is YIELD

The income return on an investment. This refers to the interest or dividends received from a security (stock) and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value.

Dividend yield is simply the annual dividend divided by the current share price, expressed as a percentage. The formula for dividend yield is: Dividend Yield = Annual Dividend / Current Stock Price.

For example, if a stock’s current price is $33 and annual dividend is $1, the "current yield" will be 3% ($1/$33). Another example: For instance, if the annual dividend is $0.40 and the current share price is $18.00, then the yield is: 0.40/$18.00 = 0.0222 = 2.22%.

Dividend yields are a measure of an investment’s productivity, and some even view it like an "interest rate" earned on an investment.

Note that dividend yield changes because of two things.

  • First, the stock price goes up (yield drops) or down (yield increases).
  • Second, the company increases the dividend (yield increases) or cuts the dividend (yield drops).

Dividend yield is an important part of your rate of return on an investment. If you purchase a stock that goes up by 8% in a year while paying you a 3% dividend, then you've earned 11% on your money.

The size of the dividend yield is often tied to the industry. For instance, utilities have traditionally been steady payers of relatively high dividends while software companies have traditionally not paid dividends (for a "zero" yield).

However, there are categories of investments where the dividend comprises a major portion of the return from the investment:

  • Real Estate Investments Trusts (REITs) (shopping malls, hospitals – big real estate)

This type of corporate structure is set up in such a way that they are required, by law, to pay out the vast majority (>90%) of their taxable income to their shareholders.

Investors interested in income are likely to be interested in companies with high yields. However in normal times, most sustainable dividends are in the (approximately) 2% to 5% range. If the company you are looking at has a yield well above that range, especially if it is above 10%, look more closely to find out why.

Earnings Per Share

Earnings per share, commonly referred to in the investment community as EPS, is one of the benchmark factors that stock analysts use to determine a company's financial health. According to the NASDAQ, changes in a company's EPS and revenue are primary factors in influencing changes in the market price of a company's stock.

At its most fundamental level, a company's earnings per share is simply the amount of the company's profits divided by the number of outstanding shares of stock. For example, if a company earned $12 million in profits and had 8 millionoutstanding shares, its EPS would be $1.50.

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