Price-to-Earnings Ratio Activity
A company’s net earnings are important, of course, since the figure represents how much money a company is making. A company can borrow money when times are lean or if the business needs to expand, but over a sustained period of time, the company must have earnings in order to remain a viable business. As such, earnings represent one of the main numbers to which an investor might pay attention, when analyzing a company’s stock.
One tool for looking at earnings is a company’s P/E ratio (price to earnings ratio). Simply, this P/E figure answers the question “How expensive is this stock in regard to what this company earns? Here’s how the P/E ratio works:
FORMULA: Per share price of stock / Earnings per share (EPS) = P/E ratio (price-to-earnings ratio)
The P/E ratio is important to investors, because the higher the number, the more expensive the stock is in terms of earnings. Most healthy companies whose stock is in good demand will have P/E ratios in the range of perhaps 8 to 22. While there are not hard and fast boundaries, the P/E ratio is one of several factors investors use to gauge a stock’s underlying value.
Example:
The Bunker Hill Shipwrecks and Salvage Claims Corporation had earnings of $1.88 in the previous year and expects the same for the coming year. The price of this stock is $30 per share. What is the company’s P/E ratio?
Directions: Determine the P/E ratio in each of the following situations. Click here for answer key.
1. Stock price is $40 with earnings of $2.40.
2. Stock price is $22.10 with earnings of $2.80.
3. Stock price is $7.50 with earnings of $0.20.
4. Stock price is $1.90 with earnings of $8.25.
5. Stock price is $3.15 with earnings of $1.05.
6. Stock price is $88.50 with earnings of $3.65.
7. Stock price is $1.40 with earnings of $0.20.
Questions to consider:
8. If you’re an investor interested in buying only companies with high-yield dividends, then why would P/E ratio mean anything to you?
9. Can you think of some reasons why a company with a reasonable P/E ratio still might not be a good investment?
10. Sometimes a company’s stock price will decline on news that earnings will be less than expected. Why do you think this is the case?
11. In what scenario could a company’s earnings rise sharply, but the company’s dividend yield drop dramatically?
Biedenweg, Ph.D., Karl, (2003). Understanding Investment & The Stock Market. Mark Twain Media, Inc., Publishers.
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