Calculating P/E ratios is easy, worthwhile
The price-to- earnings ratio is a measure that compares a company’s stock price to its earnings per share, or EPS, usually for the previous 12 months. Think of it as a fraction, with the stock price on top and the EPS on the bottom.
You can tap the stock’s price into your calculator, divide by EPS, and voila – the P/E. The ratio is calculated for you at many online stock research sites, such as http://finance.yahoo.com.
Consider Gas Prices Inc. (ticker: ARMLEG), trading at $40 per share. If its EPS for the last year (adding up the last four quarters reported) is $2, just divide $40 by $2 and you’ll get a P/E ratio of 20.
Note that if the EPS rises and the stock price stays steady, the P/E will fall – and vice versa. For example, a stock price of $40 and an EPS of $4 will yield a P/E of 10. (Savvy stock types might say that such a stock is “trading at a multiple of 10.”)
You can calculate P/E ratios based on EPS for last year, this year or future years. Published P/E ratios generally reflect past performance. Intelligent investors should really focus on future prospects by calculating forward-looking P/E ratios. Simply divide the current stock price by the coming years’ expected EPS.
Many investors seek stocks with low P/E ratios, as they can indicate beaten-down companies that may rebound. But a low-P/E stock can always fall further. Low P/Es can be attractive, but remember that P/Es vary by industry. Car manufacturers and banks typically sport low P/Es (often in the single digits), while software and Internet-related companies command higher ones (often north of 30).
Ask the Fool
Q: How do I determine my cost basis in a stock and my gain when I sell it? – L.K., St. Joseph, Mo.
A: Imagine that you buy 100 shares of International Alphabet Corp. (ticker: ABCDE) for $30 each, paying a $15 commission. Your cost basis is the purchase price ($3,000) plus the commission, or $3,015. The basis per share is $3,015 divided by 100, or $30.15. If you eventually sell the shares for $40 each, or $4,000, subtract the $15 commission and your proceeds will be $3,985, or $39.85 per share. Your taxable capital gain will be $970, or $9.70 per share.
My dumbest investment
A few years ago I was thinking about how nice Google would have looked in my portfolio when Baidu.com, a major Chinese search engine, announced its planned initial public offering (IPO). I thought there couldn’t be anything better – the up-and-coming China market combined with its own version of Google. Well, by the time my order went through, the price per share was over $150, and when it fell, it fell hard to less than $100. Needless to say, I lost a good amount because I forgot the first rule: If it’s too good to be true and you have to act now, walk away and find something better. – N.H., online
The Fool Responds: Baidu.com would still have been good to you, had you hung on. It was recently trading around $250 per share, after surpassing $400 earlier in the year. Still, it’s smart to be wary of IPOs, as they’re often for companies without strong, established track records, and their prices can be especially volatile.