P/E Ratio
P/E ratio is possibly the most scrutinized of all the ratios: A stock can go up in value without significant earnings increases - this happened most recently in the tech bubble. This means P/E shot up in some cases over 40. Without earnings to back up the price, a stock will eventually fall back down. P/E 10 - 20 are considered the normal range limits.
P/E ratio tells you how long it takes before a stock will pay back your investment. A stock @ $20 per share with earning of $2 per share has a P/E ratio of 10, which is sometimes seen as meaning that you'll make your money back in 10 years if nothing changes. You should only compare P/E ratios between companies in similar industries and markets.
Assume that you buy stock in XYZ Corp. @ $40 per share,
and that XYZ had earnings over the last 12 months of $2 per share.
The P/E ratio of XYZ stock is 20 ($40/$2)
The earnings yield of XYZ is 5% ($2/$40)
Earnings are expected to grow by 10% for the next 5 year.
What P/E ratio should XYZ stock have to make it an equal investment opportunity to a five-year Treasury bond yielding 4%?
Use a present value calculator to determine a value for XYZ
Take the 20% cumulative yield of the bond over the next 5 years and enter that as the future value (FV)
Enter "0" as the present value (PV)
Enter "5" as the number of periods (n)
Enter 10 as the annual interest rate (i)
Calculate payment (PMT)
The answer will show as -2.98
Drop the negative to find that the comparable earnings yield should be 2.98%
Divide 1 by 2.98% (.0298) and find that P/E should be 33.56
As current earnings $2 per share, the price of the stock should be $67.12 ($2 x 33.56)
Now invest $10,000 in XYZ stock @ $67.12 and get 149 shares
In Year 1, earnings per share should increase by 10%, from $2 per share to $2.20 per share
Return will be $328 (149 shares x $2.20 per share)
In Year 2, the earnings return will increase by another 10% to approximately $360 per share
Year 3 will be $396, followed by
Year 4 at $436 and finally
Year 5 at $480.
Add all these together and the cumulative earnings return $2,000
You will receive this $2,000 in the form of dividends or an increase in the stock's value or both. This is why dividend yield is a useless indicator for your stock research.
What is the P/E if XYZ growth is 20% per year?
The answer would be 44.64 and the price of the stock should be $89.28.
The earnings yield would be 2.24%
The earnings per $10,000 (112 shares) would be $269, $323, $387, $464 and $557 for a total of $2,000.
It seems intuitive that a stock with earnings growth that is projected to be greater than another's would trade at a higher P/E. Now you see why this is the case from a mathematical perspective.
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