Understanding Stocks

FUNDAMENTAL ANALYSIS: TOOLS AND TACTICS 101
ings. When you divide the stock price by the company’s earnings per
share, you end up with a P/E ratio (also known as the multiple), that
can help you determine whether a stock is fairly valued. Many people
think that the P/E is the most effective way to measure a stock. Actually,
the P/E is just one of many tools you can use to decide what
stocks to buy.
For example, a stock that sells for $20 a share and earned $2 last
year has a trailing P/E of 10 ($20 divided by $2); the trailing P/E uses
earnings from the last year. If a $20 stock were expected to earn $4 next
year, it would have a forward P/E of 5 ($20 divided by $4). In this case,
you are using analysts’ estimates concerning what will happen in the
future. The great thing about the P/E is that you can easily and quickly
compare individual stocks with one another, with their sector, or with
the overall market.
Many investors decide whether to buy a stock based on its P/E. For
example, value investors (bargain hunters looking for stocks of highquality
companies that are selling for a reasonable price) prefer to buy
stocks with low P/Es, ideally under 15. (Warren Buffett, for example,
buys only companies with trailing P/Es of 10 or less.) On the other
hand, growth investors (aggressive buyers looking for stocks in companies
whose sales or earnings are growing rapidly) don’t mind buying
stocks with high P/Es because they expect the companies’ earnings to
improve in the future. If a stock has a P/E of 50 but is growing by 60
percent a year, the stock could be a bargain.
Nevertheless, basing your stock decisions on what a company’s
earnings might be in the future has backfired on many investors. In particular,
analysts’ expectations concerning future earnings have often
been overly optimistic. For example, in the late 1990s, analyst Mary
Meeker continually urged investors to buy shares of Priceline, even
though its P/E was outrageously high (it had no earnings and an
extremely high stock price). She claimed that traditional fundamental
measurements like P/E didn’t matter anymore. That was a few months
before Priceline fell from hundreds of dollars per share to a couple of
dollars. The lesson: P/Es do matter.
Even now, misconceptions about the P/E are common. Just because
a stock’s P/E is low doesn’t mean that you should buy the stock. And