Earnings Per Share, And Price / Earnings Ratio – Two Tools For Determining Stock Viability
There is far more to owning a stock than its share price, even if it's the share price that gets all the coverage in the financial press. A share price only shows the price to buy the stock, or how much you can theoretically sell it for, but it does little to convey how much value is retained from holding the stock for the long term.
The key to determining long term value in a stock is it's price / earnings ratio. Price / earnings is, in essence, the price of a share, divided by the earnings per share. Earnings per share is calculated by dividing the total profits (less operating expenses, and preferred stock dividends) by the number of outstanding shares in circulation.
When looking at price / earnings ratio, a handy rule of thumb is to try to calculate how many years of earnings would one share have to accumulate to match the price it was originally purchased at. In most companies, this results in a ratio ranging from 10 to 15, with a few undervalued stocks hitting 7 to 8 years. One of the hallmarks of the dot-com boom was the absurdly high price / earnings ratios – some shares of stock were selling at P / E ratios of 100 or more, during the '90s.
One thing to be aware of is that there are multiple ways of calculating earnings per share; they all boil down to set asides of funds that are paid out before earnings are divided up between shares. If you have any questions about how earnings per share are calculated for a stock you hold, ask your broker for more information.
The key to earnings per share is that by holding a share of a company, you are, in theory, holding a piece of a corporation with a retained value, and you aren't speculating on the price going up indefinitely. One method of maximizing a good PE ratio stock with a stable price is to invest in a dividend purchasing plan – in essence, you're telling the company to reinvest your dividends into new shares of the stock.