Is it correct to say that a share of a stock priced at $8.00 is a better bargain than a $10.00 stock?
Sorry! If it were that easy, we wouldn't need this tutorial.
Recall our example for Lucy's Lemonade and Greg's Grape Drink. Would you rather buy a share of Lucy's at $10.00 or a share of Greg's at $8.00? Should you buy both? Either?
By creating what is called a Price to Earnings ratio (P/E), we can get a sense of the price tag of different companies.
The Price to Earnings (P/E) ratio is measured by:
Price = the current price of a share (divided by)
Earnings = or, more accurately, Earnings Per Share (for the last year of business)
For example, the newspaper lists a share of IBM for $50.00 and in its last 4 quarters of operation the EPS for IBM has been:
The P/E is computed by dividing $50.00 by $4.50
We can see that a share of IBM, selling for $50.00, is selling for just over 11 times its yearly earnings. The number 11 is a relative number used to compare IBM to other companies.
Before moving any further, consider taking a moment to see if you can answer some quick questions to make sure that you understand how to compute and analyze the P/E ratio.
Take the quiz here
OR go to Part III
What gives a share price its value? Determining future growth