Understanding Stock Markets-2

Price-earnings ratios




For stocks, the price-earnings ratio and the dividend yield are important indicators.




The price-earnings ratio, or earnings multiple, as it is sometimes called, is the ratio of the price of a company's stock to the annual earnings per share.




The P/E is simple to calculate: Divide a company's annual earnings per share into the prevailing price of one share of the stock.




If ABC Corp. had profits of $2 per outstanding share in its latest full fiscal year and its shares are trading at $18, then ABC would have a P/E of 9. If the stock was selling at $50, its P/E would be 25.What does a P/E mean and what does it indicate?




When you buy a stock, you buy a piece of the company and its profit potential. Thus, the greater the potential for growth, the higher the potential value of its shares.




A P/E of 10 indicates that the market is willing to pay the equivalent of 10 years' profits for the stock.




At 20 times earnings, the market has put a much more optimistic and thus more expensive value on the shares. A stock with a low P/E is often considered to be low growth, or mature, and a stock with a high multiple is considered to have high potential.Price-earnings ratios are also a good guide to risk.




A stock with a low P/E may not have much growth potential, but it is a lot less vulnerable to a sharp drop in price than a high flyer.




Nothing drops as fast as a stock whose profit growth does not live up to the market's optimistic expectations. As the sad truth finally dawns on investors, the stock price will drop back to a level justified by the more modest earnings.Most financial and daily newspapers provide regular information on P/E and average dividend yields.




Before you buy any security, you should always check its P/E in relation to its growth potential and compare it with other comparable stocks and to the broad market indexes