P/E Ratio Example

An easy and perhaps intuitive way to understand the concept is with an analogy:

Let's say, I offer you a privilege to collect a dollar every year from me forever. How much are you willing to pay for that privilege now? Let's say, you are only willing to pay me 50 cents, because you may think that paying for that privilege coming from me could be risky. On the other hand, suppose that the offer came from Bill Gates, how much would you be willing to pay him? Perhaps, your answer would
be at least more than 50 cents, let's say, $20. Well, the price earnings ratio or sometimes known as earnings multiple is nothing more than the number of dollars the market is willing to pay for a privilege to be able to earn a dollar forever in perpetuity. Bill Gates's P/E ratio is 20 and my P/E ratio is 0.5.

Now view it this way: The P/E ratio also tells you how long it will take before you can recover your investment (ignoring of course the time value of money). Had you invested in Bill Gates, it would have taken you at least 20 years, while investing in me could have taken you less than a year, i.e. only 6 months.

If a stock has a relatively high P/E ratio, let's say, 100 (which Google exceeded during the summer of 2005), what does this tell you? The answer is that it depends. A few reasons a stock might have a high P/E ratio are:

The market expects the earnings to rise rapidly in the future. For example a gold mining company which has just begun to mine may not have made any money yet but next quarter it will most likely find the gold and make a lot of money. The same applies to pharmaceutical companies - often a large amount of their revenue comes from their best few patented products, so when a promising new product is approved, investors may buy up the stock.
The company was previously making a lot of money, but in the last year or quarter it had a special one time expense (called a “charge”), which lowered the earnings significantly. Stockholders, understanding (possibly incorrectly) that this was a one time issue, will still buy stock at the same price as before, and only sell at at least that same price.
Hype for the stock has caused people to buy the stock for a higher price than they normally would. This is called a bubble. One of the most important uses for the P/E metric is to decide whether a stock is undergoing a bubble or an anti-bubble by comparing its P/E to other similar companies. Historically, bubbles have been followed by crashes. As such, prudent investors try to stay out of them.
The company has some sort of business advantage which seems to ensure that it will continue making money for a long time with very little risk. Thus investors are willing to buy the stock even at a high price for the peace of mind that they will not lose their money.
A large amount of money has been inserted into the stock market, out of proportion with the growth of companies across the same time period. Since there are only a limited amount of stocks to buy, supply and demand dictate that the prices of stocks must go up. This factor can make comparing P/E ratios over time difficult.
- Likewise, a specific stock may have a temporarily high price when, for whatever reason, there has been high demand for it. This demand may have nothing to do with the company itself, but may rather relate to, for example, an institutional investor trying to diversify out risk.

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