It's time to discuss an often over-used and much misunderstood yardstick. There are two types of people who read The Intelligent Investor; those who know what the letters 'PER' stand for and those who skip over them and hope they're not too important. Unfortunately, for those in the latter group, these three letters are very important, although they also hide a lot of mischief. In this article and the two that follow in coming weeks, we're going to discuss PERs in detail. While we start with the basics, we urge those with a little more experience to stick with the series because we'll get to some meatier areas in due course.
Simple comparison
PER is an abbreviation of price-to-earnings ratio. You may also see it written as PE, P/E, or p/e or even 'price earnings multiple'. No matter how it appears, the ratio is a simple way of comparing a company's current share price to its most recent annual earnings.
This is usually done on a per share basis, by taking the current share price and dividing it by the latest earnings per share (eps) figure. The result is the PER. Let's take Colorado Group as an example. The current share price is $2.71 and earnings per share for the 12 months to 31 January 2003 were $0.261. Dividing the former by the latter gives 10.4. What does that mean?
In simple terms, it represents the number of years it would take the company, at its current rate of profitability, to generate earnings equivalent to its share price. It's a common misconception that this is the number of years it will take for investors to get their money back. For that to be the case, the company would have to pay out all profits as dividends (few companies do this) and profits would have to remain constant over the period, which we've never seen.
The PER is a quick and dirty yardstick, but it can serve as a useful jumping off point for determining whether a stock may be cheap or expensive, so long as you recognise its limitations.
Visit The Intelligent Investor for the rest of this article on the price earning ratios to find out more on buying shares
