| I didn't understand this concept last week, but now I think I've got it. My second attempt at defining and understanding the concept of the Price/Earning Ratio (P/E) was much more successful. I found enlightenment in my Wall Street Dictionary definition, which is very long, but very illuminating. "The relationship between the price of a stock and its earnings per share. This figure is determined by dividing the stock's market price by the company's earnings per share figure. The higher the P/E, the more earnings growth investors are expecting. A growth stock will have a higher price/earnings ratio than a stock that is expected to grow at a slower rate. Stocks with a higher P/E, usually over 20, are considered riskier than stocks with a lower P/E, which have proven earning potential."
Yahoo! A benchmark. The magic number is "20."
First remember from a previous article, that a growth stock is one that is poised to rise quickly in price since the company is part of a rapidly growing and potentially successful industry.
Finally, a number I can look at and say, "Hmm…over 20. Is this one of the companies that has the potential of bringing a nice profit to me because I sense that it's going to be a hit with the public?" Or on the safer side: a P/E under 20 that indicates slow and steady growth.
And The Motley Fool's book You Have More Than You Think cleared things up nicely for me by stating that "The highness or lowness of the P/E ratio reflects what sort of growth the market expects for that company going forward." It's really just an expectation…a best guess number but one that is helpful to me now because I understand it!
Remember the P/E is on our stock table from two previous columns of the Mom Chronicles?
Well, it can be another possible benchmark! A P/E of, for example 58, indicates that the market expects this company to grow the fastest while a P/E of 6 for example, indicates that the market expects this company to grow the slowest. And The Motley Fool's book again clarifies further by stating, "Naturally, the market is going to expect good smaller companies to grow at a faster rate than good larger companies."
How do we know if they're smaller or larger companies? We can look at the number of shares that are traded, owned, and outstanding. I believe this is a good indicator of size.
And finally, a brief review of dividend yield from our stock table. Also check About.com for a very good explanation.
Reviewing the definition, dividend yield is the dividend (the amount the company pays us) divided by the stock price. My own beleaguered attempt at an explanation follows: dividend yield is the earning potential of a company in the future. A high dividend yield of say 8% over another dividend yield of .56% does not mean that the 8 percent is better than the .56 percent just because it's more.
If the .56% company is a fairly stable and well known company, investors are hoping that the stock price continues to rise which would also increase their dividend payment from the company. They're willing to accept a low dividend payment from the company, trusting that it will increase in the future.
Sheesh…if I didn't know any better I'd swear I sound like I know what I'm talking about. But you know…this stuff is really starting to sink in.
And why are we putting ourselves through this punishment? As I end this article, I have read multiple times in multiple places, "Do not buy a stock on price alone." Just because it's offered at $3.00 does not mean that it's a good deal. We're learning other ways to decide if a company and it's stock prices are a good deal, and sometimes that learning can be a bit painful and frustrating, but well worth the effort.
Thank you for joining me,
Joyce |
