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When investment analysts talk about a stock trading at X times earnings, they are making a comparison between the stock's market price and the issuing firm's profitability. The earnings multiple, also known as the P/E ratio, is perhaps the most frequently used benchmark for evaluating the prospects of a stock.
Before you can calculate how many times earnings a stock trades at, you must first determine its earnings per share figure, or EPS. EPS equals a company's net income after taxes, minus preferred dividends, divided by the number of common shares outstanding. Assume that the firm earned $7 million during the most recent full year, and preferred stockholders are entitled to receive $1 million per year. Further assume that the firm has 3 million common shares outstanding. Subtract $1 million from $7 million for a total of $6 million. This is how much money is left with after paying preferred shareholders. By law, preferred stockholders must be paid before common shareholders can receive dividends. Dividing the resulting $6 million by 3 million common shares outstanding for earnings of $2 per common share.
The terms "earnings multiple" and "Price to Earnings ratio," or PE ratio, mean the same thing. To calculate the earnings multiple, divide the stock price by the earnings per share. Suppose the common stock in the above example trades at $40 per share. The earnings multiple is $40 divided by $2, which equals 20. Such a stock would be said to trade at 20 times earnings, or 20 X earnings. A simple way to the same thing is to say that the stock's PE ratio is 20. While the appropriate PE ratio for a stock will depend on a wide variety of factors, such as expected profit growth in the future, risks and so on, a figure of anywhere from 10 to 20 is reasonable. As of November 2012, the average PE ratio of all stocks in the S&P 500 index was15.5.
If a stock trades at 20 times earnings, your share of the profits for each unit of common stock you own equals 1/20th of the stock's value. By taking the inverse of the earnings multiple and multiplying the result by 100, you can convert the multiple into a percentage yield. The inverse of 20 is one divided by 20, or 0.05. Multiplying this by 100 equals 5%. So the firm is accumulating profits at a pace of 5 percent of what you have invested in it.
Earnings vs. Dividends
When interpreting earnings, be careful to consider the inherent risks of stocks. A 5 percent yield from a stock investment is a very different proposition than a certificate of deposit (CD) that also yields 5 percent. While you are sure to receive the interest from a CD, a company you invest in might see its value fall the next day due to some unforeseen event. The market value of the stock might grow at an annual pace that exceeds or falls far below 5 percent, depending on investor sentiment. Therefore, you cannot directly translate an earnings multiple into an annual income stream associated with the stock.
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