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Sample P/E Ratio Calculations For Stocks: WDGT Vs. GZMO

Be Cautious Of Using Price To Earnings Ratios To Value Individual Stocks

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Price to earnings ratios can be moderately useful when looking at the stock market as a whole. However a P/E ratio can be quite misleading when looking at an individual stock.

That is because the "E" in a P/E ratio is based on either past earnings, or projected earnings, which may not be reflective of what is really going to happen. Here are the two reasons price to earnings ratios can be misleading.

  • 1. Price to earnings ratios based on past data. There is no guarantee the company’s products will continue to sell in the future as well as they have in the past. Earnings can change.
  • 2. Price to earnings ratios based on projected earnings. Analyst study past data to identify consumer trends and develop projections, but consumers are fickle, and new products can easily change buying habits. Future earnings are not predictable. The following examples will show you how using the price to earnings ratio to determine the expected value of an individual stock can be quite misleading.

    Calculating Price to Earnings(P/E) Ratios: WIDGET

    Suppose you are looking at buying WIDGET stock, symbol WDGT. Here are the facts:

    • The stock is selling at $20 per share.

    • Last year, WIDGET had earnings of $1 per share.

    • Analysts estimate the company will earn $2 per share this year.

    • P/E ratio based on past earnings is 20. Calculation: $20/$1 = 20.

    • P/E ratio based on projected earnings is 10. Calculation: $20/$2 = 10.

    This means you are willing to pay $10 for every dollar of projected earnings. This is also referred to as paying “10x” earnings, or the stock is said to have "an earnings multiple of 10".

    Comparing P/E Ratios: GZMO

    You compare WDGT stock to GIZMO, symbol GZMO. Here are the facts:

  • GZMO is trading at $10 per share.

  • Last year GZMO had earnings of $.50 per share.

  • Analysts estimate the company will earn $.60 per share this year.

  • P/E ratio based on past earnings is 20. Calculation: $10/$.50 = 20.

  • P/E ratio based on projected earnings is 16.67. Calculation: $10/$.60 = 16.67.

    In comparison to WDGT, GZMO appears to be more expensive, as you have to pay more today for the same amount of expected future earnings.

    You buy WDGT.

    The fallacy of P/E ratios when comparing individual stocks: WIDGET vs. GIZMO

    A few months after you buy WDGT, someone files a lawsuit naming one of WDGT’s well known products as a problem. People stop buying this product, and WDGT’s earnings go down. The stock price goes down too.

    GZMO, on the other hand, releases a new product that starts selling like hotcakes. GZMO’s earnings go up, and so does the stock price.

    Now WDGT is at $15 per share with $1.50 of earnings per share. It now has a P/E of 10.

    GZMO is selling at $15 per share with $.75 of earnings per share. It now has a P/E of 20.

    You decide that GZMO is growing faster, so you sell WDGT, realize your $5 per share loss, and buy GZMO.

    A year later, WDGT’s lawsuit gets dismissed. GZMO’s product, although popular, was a quick fad, and they had no more new products in the production line.

    WDGT’s stock steadily climbs to $25 per share. Their earnings rise to $2.25.

    GZMO’s stock drops to $9 per share. Their earnings go back to $.50.

    Because of constant changes, as described in the above examples, price to earnings ratios should not be used to determine if an individual stock is appropriately valued.

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