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The Price Earnings Ratio

by Ann Coleman (TMF AnnC@aol.com)

Reston, VA (February 16, 1999) -- The P/E is one of the most quoted investing numbers. It's a powerful concept that is both simple and complex. Today, let's look at the simple side.

If you weren't following the series "Why Stocks Rise?" that ran here starting January 25, it might be a good idea to hop over to our archives for a quick review. That series dealt with earnings -- the E in the P/E.

P/E means price to earnings ratio -- actually, it's the ratio of a stock's price to its earnings per share or the price divided by the EPS. Since price is almost invariably greater than a stock's EPS, the ratio is usually given as a whole number. Here's how you find the P/E:

Price = \$47.50
EPS = \$ 2.55
P/E = 47.50/2.55 = 18.627, usually rounded to 18.6 or 19.

It makes a lot of sense not to be too terribly precise when calculating the P/E. Although the earnings figure is stable, the price changes from moment to moment, so worrying about decimal places is a bit silly.

The P/E is a kind of unit pricing for stocks. You know how to find the best buy on tuna, don't you? Rather than trying to figure out whether two little cans at \$0.86 is a better deal than the big can at \$1.69, you just look at the unit price (usually next to the actual price on the shelf below the product), and it will tell you the equivalent price per pound for each size.

The P/E does the same thing for stocks. It tells you how much the stock costs per dollar of earnings. Since earnings are the single most important thing about a stock (if you are in doubt about that, click here: Why Do Stocks Go Up?), the P/E lets you compare stock prices on an equal basis -- more or less. (Tomorrow we will get into the difference between chunk light and albacore.)

Investing is sometimes described as buying the right to a piece of a company's future earnings stream. The P/E tells you what that right costs you in terms of today's earnings.

Sometimes you will hear a P/E quoted in terms of anticipated earnings, as in the "year-ahead P/E" or the "forward P/E." What the writer is doing there is comparing the price to what the company is estimated to be earning in one year's time. Such comparisons are often made in the context of "It's expensive now, but if the estimates are right, in a year, the price will look cheap relative to those great earnings we are all expecting."

Normally, though, the P/E is based on the current price and the trailing twelve-month (sometimes abbreviated TTM) earnings, meaning the sum of earnings from the last four quarters. (By the way, it is never based on fiscal year earnings except when the fiscal year IS the previous twelve months. You always want to use the most recent earnings.)

Let's take a look at our current portfolio leader, Caterpillar (NYSE: CAT), as an example. CAT is up a bit over 3% since we bought it December 24. A detailed quote for CAT from quote.fool.com gives its P/E as 11. Earnings last year were \$4.11 (since CAT is on a calendar year, the company's latest yearly earnings are the same as the trailing twelve-month earnings) and the current price is around \$44.50. (44.50/4.11 = 10.8).

The discrepancy is caused by a lag in recalculating the P/E. If a stock has changed rapidly during the day, it's not a bad idea to check the Data area of quote.fool.com for the latest earnings (under Financials) and calculate it yourself.

OK, end of lesson, but today we have homework. If you want to check your expertise in calculating P/Es, use today's closing price for each of our Foolish Four portfolio stocks and calculate the P/E based on the earnings you find at quote.fool.com. I will provide the answers tomorrow.

Fool on and prosper!

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02/16/99 Close
 ```Stock Change Last -------------------- CAT + 7/16 45.25 JPM +1 7/8 110.25 MMM - 15/16 76.44 IP - 3/4 41.94 ```
 ``` Day Month Year History FOOL-4 -0.05% 3.14% 0.98% 2.48% DJIA +0.24% -0.66% 1.41% 1.00% S&P 500 +0.95% -2.95% 1.35% 1.59% NASDAQ -0.35% -7.66% 5.53% 6.97% Rec'd # Security In At Now Change 12/24/98 24 Caterpillar 43.08 45.25 5.04% 12/24/98 9 JP Morgan 105.51 110.25 4.49% 12/24/98 14 3M 73.57 76.44 3.90% 12/24/98 22 Int'l Paper 43.55 41.94 -3.70% Rec'd # Security In At Value Change 12/24/98 24 Caterpillar 1034.00 1086.00 \$52.00 12/24/98 9 JP Morgan 949.62 992.25 \$42.63 12/24/98 14 3M 1030.00 1070.13 \$40.13 12/24/98 22 Int'l Paper 958.12 922.63 -\$35.50 Cash \$28.26 TOTAL \$4099.26 ```