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Intro to stocks

Price/Earnings Ratio

The Price/Earnings (P/E) ratio is calculated as a stock's market price, divided by its earnings per share (EPS). Investors often use what is called a trailing EPS figure, which is simply calculated as the sum of a company's latest four-quarterly EPS figures. By itself, the P/E ratio can be misleading, and its interpretation has been subject to much controversy. Nevertheless, it is a widely used ratio that appears daily in many financial publications and analysis. To better illustrate the differing interpretations of the P/E ratio, we will split the argument into two camps, A & B.

Camp A believes that behind the P/E ratio is the idea that because a company's stock price should reflect the market's expectation of future performance, P/E compares the present performance with those expectations. Therefore, it stands to reason that those companies with high P/E's are expected to show greater future performance than their current levels, while those with low P/E's are not expected to fare much better in the future.

Camp B includes those investors that believe a company with a low P/E ratio is often an indication of an undervalued situation. Investors who practice this strategy, will often compare an individual company's P/E to the industry average P/E, selecting companies who fall below the average.

Camp A assumes that all investors or at least a large enough body of investors have equal and easy access to all company and industry information, and can interpret this information correctly. In the specific case of small-cap stocks, we disagree with these assumptions of access and the ability to correctly interpret information. Often, emerging under-followed companies tend to exhibit a lag period between the time when positive financial information is released and when the company finds its way onto the "radar screens" of the institutional investment community. This can be due to the fact that, even with electronic financial filing, the information may still be hard to access, or because the company has yet to be uncovered by large volume buyers. Indeed, the assumption of correct interpretation is an even greater leap of faith. Two analysts, facing the same raw data, with identical levels of training, education, and experience will often reach very different conclusions on the current and future prospects of a company.

As for Camp B, we do not necessarily agree fully with their methods, either. There are many unpopular companies trading at low P/E ratios for good reason (slow or minimal growth), and many rapidly growing companies, which fully deserve their high P/E's.

In the end, we suggest that you take a company's P/E ratio with a large grain of salt. It can be useful when comparing similar companies within the same industry. However, it is only one tool in your tool box and by no means a substitute for a comprehensive company analysis.

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