Combining P/E and P/Sales to determine a stock's valuation

Stock Valuation - The Price to Earnings Ratio

In my previous article, I wrote about the Price to Sales Ratio, a very valuable tool in a value investor's toolbox. I now continue the Stock Valuation series with another valuable tool - The Price to Earnings Ratio. All of the tools in this series are valuable by themselves, but when combined together, they make the task of stock picking methodical and very profitable.

The Price to Earnings Ratio is also known as the Earnings Multiple or Price Multiple. Most people refer to the ratio simply as the "P/E".
The formula for calculating the P/E is simple: P/E Ratio = Share Price / Earnings per Share

For example, if a stock is trading at $22.00 per share, and trailing earnings is $1.15 per share, the P/E ratio is 19.13 (22.00/1.15).

Typically, the lower the P/E, the more attractive the stock is to a value investor. Just like the Price to Sales Ratio, the P/E is very useful for comparing multiple companies within the same industry.


Let's compare the P/E's for two companies:

Pear Computer:
Share Price: 54.27
Earnings per share: 5.72
P/E Ratio: 54.27 / 5.72 = 9.49

Fastway Computers:
Share Price: 38.12
Earnings per share: 1.96
P/E Ratio: 38.12 / 1.96 = 19.45

As you can see, Pear Computer has a much lower P/E than Fastway Computers.

The P/E is referred to as the "multiple", because it indicates how much investors are willing to pay per dollar of earnings. If a stock is trading at a multiple (P/E) of 15, that means that an investor is willing to pay $15.00 for every $1.00 of earnings. A high P/E is a warning sign that a stock may be over bought, which means it may be "hyped up" and valued too high.

Even though the P/E is a valuable tool, it is very important that you don't base the value of a stock on its P/E alone. The reason for this is, the earnings figure is based on the honesty of the company's accounting practices and is susceptible to manipulation. You should always use the Price to Sales Ratio, that I wrote about previously, in addition to the P/E to determine a stock's valuation.

Let's add in the Price to Sales Ratio to our two stocks and see how they compare (see my previous article for the Price to Sales calculation:

Pear Computer:
P/E = 9.49
Price to Sales = 1.46

Fastway Computers:
P/E = 19.45
Price to Sales = 3.15

By comparing the ratios of these two stocks, it is clear which one has the better value. Both the P/E and the Price to Sales are more than double for Fastway compared to Pear. When it comes to picking stocks for a portfolio of value stocks, Pear Computer is the clear winner.

http://www.xomba.com/stock_valuation_price_earnings_ratio

http://www.xomba.com/stock_valuation_price_sales_ratio