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Beginner’s guide on price-to-earnings ratio in stock price analysis

04.22.2012 · Posted in Day Trading

Day traders often use Price/earnings (P/E) ratios of various stocks as their primary indicators of stock performance. Your financial adviser or Yahoo finance website would tell you right away that P/E ratio is one of the informative indicators to consider.

Price to earnings ratio in technical analysis of financial markets is calculated by dividing today share price by earnings per share (EPS) usually over the last year. If the price of MMM stock is 89.90 dollars and EPS was 5.96 then division results in 15.08. What about P/E when price drops to 68 dollars? Check yourself!

Although computing P/E is quite simple, its interpretation is not so easy. Day traders buying MMM stock at the price of 89.90 will pay 15 dollars for each 1 dollar of earnings that 3M stock produces. Thus, “multiple” is another name for price to earnings ratio. Notice that P/E calculation is not possible when corporation makes zero or negative profits.

Many professional investors say that this interpretation may be misleading. In particular, P/E ratio that we computed above evaluates the past and not future earnings. Investors, on the other hand, may have also some idea about future earnings of the company.

To make a specific example assume that MMM doubles earnings per share in 2012. In this case buyers of MMM stock foresee that the actual price is only 8 dollars per each 1 dollar in earnings. On the other hand, if earnings drop to 2.98 in 2012 then the multiple will be as much as 30 dollars.

On average, the price to earnings ratio has been in the range 15 to 25. However, the results will fluctuate depending on the industry and the exchange rate with major currencies.

Beginners refer to P/E ratio compared to a stock price because it gives a better prospective. McDonald’s equity that sells at 50 dollars and has a P/E of 50 is actually more costly than some other $75 stock with a P/E of 20.

Despite its popularity P/E also suffers from many drawbacks. The stock price is an objective number, but EPS can be manipulated to show the better picture. In a complicated modern world even stock investment companies cannot always catch dishonest companies.

Low P/E may indicate that a company is entering some zone of high turbulence. But selling a stock with P/E of 5 without taking into account other technical indicators is also not a good idea.

Before selling such stocks experienced investors typically look at the P/E ratios of bigger players in the industry. More advanced analysts study the inflation dynamics which typically drives P/E down. The reason is that inventories tend to be understated when prices are quickly rising.

Price to earnings ratio is a decent measure of investor’s optimism in, say, Alcoa stock. Lower P/E compared to other firms in the industry is an early alarm predicting a drop in future earnings

Looking to find the best deal on stock price analysis, then visit www.freestockresearch.net to find the best advice on stock investment companies for you.

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