P/E Ratio the "Multiple"

Understanding P/E ratios can lead to making money!

How much is a stock worth?  How much does it cost compared to its competitors?  People tell me things at work all the time like, "Hey Sprint stock is only $2 a share, it is so cheap I should buy that right?!?!"  The answer to that question is always an easy, "NO!".  Then they tell me that Sprint is so cheap, especially when compared to AT&T and Verizon.  They say, "AT&T's stock costs $29.73 and Verizon's stock costs $38.34 that is WAY MORE expensive then Sprint's $2.19 stock!!!"  They are being mislead though, the stocks quote price has little to do with the stocks value.

When you buy a stock you should not look at it like buying a piece of a company.  After all if you buy ten thousand dollars worth of Sprint stock what are you expecting to get from that purchase?  Hopefully you were not thinking that you can go to a Sprint store and just grab a cell phone and walk out or that you can stop paying your mobile service bill if Sprint is your carrier.  When you buy stock you are purchasing a chance to share in the profits that the company makes on a per stock share basis.  The profits that a company makes on a per share basis are referred to as the companies/stocks earnings per share or EPS.  Once we know the EPS we can find the P/E Ratio by taking the Price (P) of the stock and dividing it by the Earnings (E or EPS).  So the P/E ratio for AT&T is figure like this.  The P, price per share of stock $29.73, divided by E earnings per share EPS $1.97 equals the P/E ratio of about 15.  So the P/E ratio for AT&T is 15.  That means that investors are paying 15 times earnings per share to own the stock.  This is why the P/E ratio is also referred to as the "Multiple".

Now that we know how to find the P/E ratio we can compare companies that are competing against each other like Verizon, AT&T and Sprint.  AT&T has a P/E of 15, Verizon has a P/E of 15.39, and Sprint has a P/E of -2.61.  So a stock that people thought was cheap was is actually expensive because the company behind it is losing money!  I personally do not choose to invest in or trade the stocks of companies that are losing money.  You can also use the P/E ratio to compare a stocks value to the average value of all the stocks of the index it trades on.

When looking at stock prices in the future, please remember that the quote price does not tell you close to as much about a stock's value as the P/E ratio does.  The P/E ratio can tell you the a lot about the true value of the stock compared to the overall market, sector, and the competition.