How To Use P/E To Compare Stock Values

In a previous blog (here) I took you on a quick tour of the Yahoo! Finance and explained what some of the numbers and ratios mean. Today I will expand on one of the most prevalent ratios when analyzing stocks, P/E or the Price to Earnings ratio, also known as "the Multiple". Calculating this ratio is simple. You just take the stock price (P) and divide it by the earnings per share (E or EPS). The hard part is interpreting the P/E. There are no hard and fast rules that indicate what is a good or bad P/E.

You will find that this is a continuing theme in stock analysis. I would love to provide you with a check list of what makes a great stock but we live in a complex world where context is very important.

Using P/E to compare stock values

P/E serves a couple important functions. First, it provides a means of comparing the value of companies of different sizes. A common misconception when people look at stock prices is that a higher priced stock is more expensive than a lower priced stock. The truth is that there are a lot of factors that change a stocks price but to keep it simple consider these two;

• How much is the company worth? 
• How many shares of stock are in circulation?

Theoretically, if both of these numbers were concrete and indisputable you would just take the first number and divide it by the second (company worth / total shares) and that would give you a concrete stock price. Unfortunately, the first bullet is not a concrete number though. Many people will have many different opinions on a company's worth or total value. 

Since the company's total value is not concrete, financial analysts look to a company's earnings instead. Earnings are concrete, indisputable and reported quarterly by every publicly traded company. But stock analysis is about comparing company's to one another. How do you do that for companies of different sizes? McDonald's (MCD) is the largest fast food chain in the world. How can we compare its stock to say, Chipotle Mexican Grill (CMG). We just add up the previous four quarters worth of earnings (1 year) and divide that by the total number of shares in circulation. That gives you the Earnings Per Share (EPS).

EPS shows you the earning power each share represents, essentially telling you how much your portion of the company earns for each share you own. It is easy to assume that higher numbers are better but that isn't the whole story. What you and I am concerned about as investors is the value of a stock and to find that you have to consider what it cost, its price. That is where the P/E ratio comes in.

For example;

Apple (AAPL) has a stock price of about $393.30 and a EPS of just $25.56.

Coinstar Inc. (CSTR), owner of Redbox movie kiosks, has a stock price of about $54.23 and a EPS of $1.62.

At a glance most people would say that Apple is more expensive than Coinstar but Apple also has a much higher EPS and that has to count for something, right? How can you definitively compare them? You take the stock price and divide it by the EPS. It shakes out like this;

Apple: $393.30 / $25.56 = 15.56
Coinstar Inc: $54.23 / $1.62 = 33.54

What do these numbers mean? Well, at the current price you have to pay over 33 times what Coinstar has earned per share to by the stock where as you only have to pay just over 15 times EPS to purchase Apple. This seems to indicate that Apple is curently a better value despite the fact that the stock costs almost $400 per share.   

Analysis does not end there, of course. A lower P/E does not necesarily mean that the company is a better value or that it will provide better returns. But now you should have a better understanding of how and why those ratios were derived. I will follow up with another post that discusses P/E as an indication of potential earnings growth pretty soon. As always, f you have any questions feel free to post them to my comments section below and I will respond quickly. Thanks for stopping by.