Last week we dove in with our beginning investor series on terms that all investors in the equities (stocks) should know.  As usual I dove in before I checked if I was at the shallow end of the pool. Ouch, what was I thinking EBIT? Let me start over.

P/E or Price Earnings Ratio is the single most discussed concept there is in stock investing. That doesn’t mean it is the most important. Because a mind numbing number of people discuss Paris Hilton doesn’t make her important. O.k. maybe I have gone too far. P/E is more important than Paris Hilton. It is just overused and its limitations are not always understood by novice investors.

First, what is P/E or Price to Earnings ratio? This is the relationship of share price to earnings per share of that stock. Or more precisely it is Price per share /Annual Earnings Per Share. EPS is expalined in the EPS post.  Earnings Yield is the opposite of Price Earnings. It is used by some investors to calculate potential future return of a stock  because it is expressed as a percentage. Joel Greenblatt used Earnings yield in his famous magic numbers equations. The idea with P/E is to relate what the price of a stock is to how much the company is actually earning. This number is then compared to other stocks. The common wisdom is that a low PE means the stock is cheap and that a high PE means the stock is expensive. There is some research that suggests that buying low P/E stocks over time will result in a better returns (Stocks for the Long Run pg. 112). This is often true, but not always. Some industries have traditionally maintained higher PE’s than others. Tech stocks for example often have what would seem to be obscenely high PE’s. Many insurance or reinsurance companies have low PE’s. So while a general look at PE may be useful it often needs to be tempered with other comparisons within its industry or in relation to historical averages.

While many investors use PE as their primary metric for judging value of a company, it is not one I use with much frequency. It is still an important investing term to understand.

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