Because part of a stock's intrinsic value is the
percentage of a company's earnings it represents, one of the most
popular valuation methods is looking at earnings-per-share (EPS) — the company's total earnings divided
by the number of shares — and at the price-to-earnings ratio (P/E). The P/E, which is the stock's share
price divided by its EPS, tells you how much investors are currently
willing to pay for each dollar of the company's current earnings.
If a stock's P/E is higher than the average —
historically about 15 for the market as a whole and more recently
closer to 22 — then investors are willing to pay more, perhaps
because they believe that earnings will rise dramatically. But
if analysts believe that the P/E is too high and investors are
paying more than the stock is likely to be able to deliver, they
say the stock is overvalued.
Bargain hunting
If a stock's P/E is lower than average, it may
attract investors looking for a bargain, but it may also be a
sign that the market is staying away with good reason. If an analyst
believes a P/E is too low in light of a company's future earnings,
the analyst says the stock is undervalued.
Value investors — those looking for stocks
trading at bargain prices — have traditionally been on the
lookout for solid companies trading at low P/Es.
Sam Stovall,
Chief Investment Strategist at Standard & Poor’s
Sam Stovall of S&P discusses whether investors should set a P/E target for a company.
Price-to-earnings
targets can be helpful if the stock you own is in a
cyclical industry
that has a long enough history to have established
a P/E range. But many "new economy" stocks, while still cyclical
in nature, have not been around long enough to have a P/E range. In addition,
a stock's P/E is only one of many variables that analysts look at.
Besides, recent high-profile lawsuits have brought to light the many methods
companies use to manage reported earnings. Many investors use other valuation
methods (or "metrics"), such as
EBITDA,
free-cash flow, and
debt-to-equity ratios
to help determine a stock's risk and reward
potential.
Sam Stovall, 