Using the P/E Ratio or Price/Earnings Ratio to Evaluate Stocks
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Investors look for stocks that will generate the highest returns on their investment (ROI). One method of determining the value
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of a firm's common stock is to calculate its Price/Earnings (P/E) ratio and then compare it to the P/E ratio of the market (S&P 500) and/or its peers. The P/E is calculated by taking the market price per share of common stock and dividing it by the earnings per share (EPS) over the past 12 months.
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P/E ratio = Price per Share/Earnings per Share
P/E is one market value ratio that is widely used and easily attainable from any financial publication. P/E must be used carefully when evaluating companies in different sectors. The average P/E in the technology sector is much higher than the average P/E in the utilities sector. It would be difficult to compare these 2 sectors utilizing P/E alone. It would be an incorrect assumption to believe that InfoSpace, Inc. is comparable to companies in the utilities sector because they share similar P/E's.
| Company | P/E | Company | P/E |
| Google Inc. | 73.44 | Pacific Gas & Electric | 16.33 |
| Yahoo! Inc. | 26.86 | The Southern Company | 15.84 |
| InfoSpace, Inc. | 10.48 | FPL Group, Inc. | 16.27 |
| Average | 36.93 | Average | 16.15 |
As an investor, it is prudent to select an industry in which you have extensive knowledge. Search engines for example, is a competitive field; Google and Yahoo! lead the category. P/E is a great tool to compare these two companies. Both companies have large advertising units that generate the majority of their sales. Yahoo! has several other revenue generating properties and services that help Yahoo! to weather changing advertising trends. However, Google owns a larger share of the search traffic: 42.3% v. Yahoo!'s 36.3%, as of March 2006.
Looking strictly at the price/earnings ratios of Yahoo! and Google is a good way to compare these two companies. Yahoo! is an older company and has several established web properties in which it can place its advertisements; this is a major component of annual sales.
Google has grown rapidly, buying and creating its own web properties to challenge Yahoo! http://www.gmail.com, http://finance.google.com/finance, and Google's new payment gateway (http://checkout.google.com credit card processing system) is a contributing factor of an increased P/E. Investors purchasing Google shares accept a large risk for higher potential returns. Investors will pay a premium for Google shares because there is a greater chance for larger returns, as compared to investing in other, similar companies. These larger returns may never materialize.
Higher P/E's tend to indicate a riskier investment with rewarding returns, while lower P/E's signal declining earnings which deliver lackluster returns. This generality is not always consistent; in the realm of the search world, Yahoo! might be considered a safer or a more conservative investment since its users stay for longer periods of time and utilize several of Yahoo!'s web properties such as Yahoo! Fantasy Sports, Yahoo! Mail, and Yahoo! Shopping. These web properties ensure a consistent flow of traffic and steady advertising sales.
P/E ratios are a quick way to sort out the leaders within the same sector. Never use a P/E ratio exclusively to make an investment. Remember, a P/E is measured using historical trailing earnings for the past 12 months and do not necessarily indicate strong future earnings. Price/earnings ratios when used with other market value ratios can help investors to make consistent returns and to minimize loses.
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