Rule One Investing Blog

In my last post about re-analyzing the PE of LOW it occurred to me that I don’t 100% understand PE. In the Book Rule #1 , Phil Town briefly explains PE and how it’s calculated. Let’s start how it’s exactly calculated

PE = Current Price/ Earnings Per Share (EPS)

So if a stock has a EPS of $2.00 and a current price of $40 then the PE would be (40/2) = 20. This means that the current price and the PE are related and related to the number of shares. Therefore, anytime the EPS is diluted (stock options) this decreases the Price per earnings. So as Phil Town states “The PE ratio indicates how much we’re willing to pay for a dollar’s worth of a company’s earnings”

Using a quote from Investopedia

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn’t tell us the whole story by itself. It’s usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company’s own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

So the PE is the price that the market is willing to pay for $1 of earnings and when we have a high PE then we’re expecting more earnings. Putting this into context of our current market. If we’re expecting a recession then the earnings in the future are expected to decrease, therefore, the market is willing to pay less for $1 of earnings.