Financial Reports: How to Use the Price/Earnings Ratio to Judge Company Market Value - dummies

Financial Reports: How to Use the Price/Earnings Ratio to Judge Company Market Value

By Lita Epstein

For financial reading purposes, how do you know what a reasonable P/E ratio is for a company? Historically, the average P/E ratio for stock falls between 15 and 25. This ratio depends on economic conditions and the industry the company’s in. Some industries, such as technology, regularly maintain higher P/E ratios in the range of 30 to 40.

In addition to comparing two companies, you need to compare the P/E calculation to the industry of the companies. Doing so allows you to gauge stock price or market value not only for the companies whose annual reports you’re analyzing, but also for other companies in the same business.

One way you can find out the average industry P/E is to look up a company on Yahoo! Finance. On its home page, you see a link for industry information. Toy companies fall into the Toys & Games industry category. In June 2013, Mattel and Hasbro beat out all industry players significantly. The next-closest toy and games company was Gaming Partners International Corporation, with a P/E of 12.15.

The P/E is a good quick ratio for picking potential investment candidates, but you don’t want to use this ratio alone to make a buying or selling decision. After you pick your targets, read and analyze the annual reports and other information about the company before making a decision to invest.

If you want to start your research on potential investment opportunities based on leaders or laggards in an industry, you can find a summary for all industry statistics on Yahoo! Finance.

You may wonder why someone would even consider laggards as investment opportunities. Well, you can sometimes find a company that many investors think is a dog but is actually terribly undervalued and doing the right things to recover from its current slump. This style of investing is called value investing.

When investors are bullish, they tend to bid up the price of stock and end up paying higher prices for the stock than it may actually be worth. This price-bidding war also drives up the P/E ratio.

The market sets stock prices based solely on the price at which someone is willing to sell a stock and the price at which someone is willing to buy a stock.

During the Internet and technology stock bubble of the late 1990s and early 2000s, P/E ratios hit highs in the hundreds and tumbled dramatically after the bubble burst. Even big names, such as Microsoft, had P/E ratios over 100 that dropped back to realistic levels when the bubble burst. In July 2004, Microsoft’s P/E was 41.37, so you can see that investors can seriously overbid even a top company.

By June 2008, Microsoft’s P/E had dropped dramatically to 16.14. In 2013, Microsoft still carried a much lower P/E than in 2004. In June 2013, the P/E was 17.11. Its new operating system, Windows 8 didn’t do as well as expected, and the losses in the European courts hurt the company’s future earnings potential. Investors are no longer willing to overpay for its stock.

Be careful when you see P/Es creeping above their historical averages. Usually you’re encountering a sign that a correction is looming on the horizon and will bring stock prices down to realistic levels. Do your homework while you wait for the correction, and be ready to jump in after the correction and pick up the stocks you want on sale.