The Right Questions to Ask About Stocks: The Price to Earnings Ratio

Welcome to the second post in our series on The Right Questions to Ask About Stocks. In the first post, we learned what a company’s earnings were -- and how you could determine if there were any!  Today, we are going to look at the price to earnings ratio, or P/E, and determine how it can help you.

What Exactly is a Price to Earnings Ratio?

Price = The cost of stock shares. Earnings = The company's profit.

When you divide the stock price by the earnings per share, you get the P/E ratio: how much the company is earning per share in relation to its stock price.

For example, if a stock costs $20 per share and that company is making $2 of earnings per share, the P/E is 10.

As a test case, let's calculate the P/E for Columbia Sportwear (COLM):

While it's good to know how to calculate a P/E, this is probably the first time I've done it in years. It's easy to get them from just about any stock quote. For example here it is on Google Finance:

http://www.google.com/finance?q=NASDAQ:COLM

Why Do I Need To Know A Company’s Price To Earnings Ratio?

Speaking of Columbia Sportswear, picking a stock can be a lot like picking out good running shoes -- you don’t just want to buy the first pair you find. Instead, you'll take the time to look around and try on many different styles, eventually choosing the one that fits your specific needs. Of course one of the most critical decision factors is going to be the price.

You might think that Merrells are much better than Columbias. But if the shoes you like cost ten times more than your second choice, you'll likely take the second choice. You have to consider the quality of the shoe in relation to the price. This is how the P/E ratio helps us when choosing stocks. It relates the quality (the company's earnings) to the price.

For example: at present, Merrell’s footwear is under Wolverine World Wide, Inc, whose P/E is at 15.41; and Columbia Sportswear Company’s P/E is at 23.89, as we calculated.

That means Wolverine investors are willing to pay just over 15 times what the company makes in earnings, while Columbia investors are willing to pay nearly 24 times the company's earnings.

Great.  I Know What It Is And How To Find It.  How Can It Help Me?

While earnings aren't the only way in which a stock can be "good," this ratio helps you eliminate a lot of variables and get a simple value for comparing stocks. Now, you can begin to determine whether the stock is overpriced, or if there is a reason it is selling for more.  This could be overconfidence in a brand name, or investors may be banking on the expected future earnings.  Has Columbia come out with a new line that has been predicted to take off or are you looking at a little stock bubble getting ready to burst?

So while the P/E isn't an answer in and of itself, it gives us a common frame of reference. Based on their earnings I know that Columbia is priced more dearly than Wolverine. There may be good reasons for this, but at least I now know I should start looking for them. P/E gives you a nice starting point for doing your homework.

This article is part of the Festival Of Stocks. Be sure to go there to check out more great posts about stock market investing.