Stock brokers and investors often look at certain fundamental information about a stock when determining if that stock is a good stock to purchase. One of those fundamental indicators is the “P/E ratio” of a stock. While we favor low P/E stocks, often called value stocks, buying a stock simply because it has a low P/E is like assuming a car is fast because it has racing stripes and a number on the side.

The P/E ratio is the ratio of a company’s share price (P) to its earnings per share (E). The most common way of computing this number is by taking the current share price and dividing by the earnings per share from the last 12 months. This is known as the trailing P/E because it uses the actual historical information from the last four quarters. For example, recently General Electric (GE) was trading at 34.44 and had earnings per share (EPS) the previous year of 1.61 for a P/E ratio of 21.4.

Now, imagine a company – we’ll call it “Old-Fashioned” – whose stock is trading at $40 and has trailing earnings of $4 a share. This company’s P/E ratio is relatively low at 10. Assuming that the company’s earnings did not change, it could afford to pay a dividend of $4 a year per share. Even if the stock’s share price did not appreciate, shareholders would receive 10% of their investment back every year in dividends. In ten years they would be repaid their original investment and still own their shares of stock.

In very simplistic terms, a stock’s P/E ratio is a measure of how long it would take at the current level of earnings to be repaid for your investment. Said another way, the P/E ratio tells you how many dollars you have to invest to receive $1 in earnings.

Imagine another company – we’ll call this one “New-Fangled” – whose stock is trading at $40 and has trailing earnings of only $1 per share. This company’s P/E ratio is relatively high at 40. Assuming the company’s earnings did not change, it would take 40 years for the earnings to justify the stock’s purchase price.

Let’s assume that New-Fangled’s sales are projected to double each year for the next ten years. Although last year’s earnings were only $1 a share, next year they are projected to be $2 a share. The leading or projected P/E, which uses the estimated earnings expected over the next four quarters, would be 20. And if the doubling of earnings each year actually happens, the stock’s purchase price would be more than compensated in five years.

In fact, even if New-Fangled’s earnings only double for the next two years and then stop, it will end up with a P/E ratio just as good as Old-Fashioned’s P/E ratio.

While both stocks are trading at $40 per share, Old-Fashioned is assuming flat or declining sales while New-Fangled is assuming a measure of growth in company earnings. Given everything that is known about these two companies, the market has priced each stock appropriately.

However, if Old-Fashioned maintains its market share, or if it doesn’t decline as much as was expected, the stock price could go up with the realization that earnings won’t be declining. On the other hand, if New-Fangled reports earning growth of 30% when the markets were counting on 50%, the stock price could plummet.

Each stock ends up trading at where the markets find equilibrium. Investors are willing to pay more for the earnings from companies with better growth prospects. That’s why investors may be willing to pay $40 for every $1 of earnings that a growing company generates.

P/E is a better indicator than stock price of how cheap or expensive a company’s stock actually is. Stocks with high P/E ratios are expensive, even if their share prices are low. A stock’s share price changes with splits and reverse splits, but these do not change a stock’s P/E ratio. The P/E ratio is a better indicator for the cost of buying an earnings stream.

Stocks with a rising P/E ratio could be considered more or less speculative depending on your perspective. Stocks with a constant low P/E ratio have no prospects for growth and are risky because they are unlikely to improve their earnings per share. Stocks with a high P/E ratio, on the other hand, are considered by investors to have good prospects for growth. They are risky because there is a chance they won’t deliver the growth of earning that investors are counting on and then their share price will plummet.

Since a company’s prospects for growth affect the multiple of earnings that investors are willing to pay for a stock, some industries have lower average P/E ratios. The growth of gas utility companies is very limited; hence the average P/E ratio of that industry is currently 9.8. Internet Information Providers, on the other hand, have an average P/E ratio of 54.

This explains why companies like Google (GOOG) and Yahoo (YHOO) have P/E ratios of 59 and 30 respectively.

On July 19th, Yahoo’s stock price fell 21.8% in a single day even after announcing solid second quarter results that met analyst estimates.

The drop caused a corresponding drop of Yahoo’s P/E ratio as investors lowered the expectation that Yahoo will be able to keep its market share. Yahoo still has a larger share of the Internet audience but Google is gaining ground.

Yahoo makes more money than Google in visual advertising, but search advertising has become the larger market. Investors are betting on Google. Currently Google gets 49% of the Internet search engine traffic verses Yahoo’s 24%. That’s why the value of Google’s stock is about $124 billion, over three times Yahoo’s value of $35 billion.

On the other end of the spectrum, Exxon Mobil (XOM) had a P/E ratio of 10. Chevron (CVX) had a P/E ratio of 8. Conocophillips (COP) had a P/E ratio of 5. Although the oil and gas industry has had phenomenal profits in the past year investors don’t think they will last. The markets have discounted the value of these past profits and are pricing these companies as though they expect their earnings to shrink.

While we recommend over-weighting stocks with low P/E ratios, your portfolio should include a broad spectrum of stocks, including a generous helping of growth-oriented stocks. Balancing your portfolio can be a simple and straightforward process, if you have the tools and experience. On your own, it may be as difficult as using a hammer to adjust your car’s timing belt. To have a fee-only financial planner tune your portfolio to get you where you want to go, visit the National Association of Personal Financial Advisors at  www.napfa.org.

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