Analyzing stocks: the p/e ratio
Analysts at Delaware Investments rely on many statistics when evaluating stocks for possible inclusion in a given mutual fund. Among the basic measurements is the price to earnings ratio (often referred to in shorthand as the P/E ratio). This ratio compares a stock's price per share with its earning per share. It helps analysts and portfolio managers decide if a company's stock is attractively priced in light of the company's recent earnings results. (The ratio can also be calculated based on a company's estimated future earnings.) The ratio is often used as a comparative measure — analysts compare the P/E ratios of various stocks to get a sense of how "expensive" each one is relative to its peers.
In some circumstances, the P/E ratio is influential in determining whether a stock makes it into a given mutual fund. In those cases, the ratio serves as a sort of first-line measure — a type of "screen." Often, the ratio gets considered within a broader, nuanced investment process that relies on analysis of additional ratios. For instance, a certain level of P/E can sometimes trigger a more careful consideration of a stock's valuation, in which analysts look beyond earnings to other financial measurements such as revenue or book value.
A word about limitations
P/E ratios can be expected to vary with economic cycles, and can become worthless measurements during economic downswings, when companies might not have any positive earnings to report. This limitation is among the reasons why professional investors consider P/E as part of a wider analysis that includes other measurements.
The p/e ratio demystified
Let's say the price of a company's stock is $20, and its earnings per share for the most recent fiscal year is $2. To calculate the p/e ratio, the stock price is divided by the earnings per share:
The result tells us that based on current prices, investors believe each share of stock is worth ten times its earnings. To put it another way: investors are willing to pay $10 for every dollar the company earns.
A P/E ratio of 10 is generally considered to be in the low range. A ratio between 10 and 20 is in the middle range, and a ratio above 20 is in the high end. Generally speaking, the higher the P/E ratio, the higher the expectations about the company's future earnings. Again, it's important to remember that these ranges are not absolute; for instance, P/E ratios can be different for stocks in different business sectors. By their nature, some sectors trade at higher P/E ratios than others. P/E ratios can also fluctuate based on type of company; fast-growing, dynamic companies often have higher P/E ratios than mature, slower-growth companies. Professional investors keep these differences in mind.
All in the family: three close cousins to the p/e ratio
Here are three other ratios that take an aspect of a company's performance and relate it back to its share price. Just like the p/e ratio, these ratios are used as measures of valuation.
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Price to earnings growth. Also known as the PEG ratio, it plays an important role in understanding a stock's potential value. Analysts calculate it by dividing a company's p/e ratio by the expected rate of earning growth.
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Price to sales is the comparison of the price per share to sales per share. Like the other measures listed here, it's based on values over time (usually one year) rather than at any specific point in time.
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Price to book. The company's share price divided by the company's book value. Like other price-based ratios, it tells us if a stock is expensive when compared to peers.
Important information
Investing involves risk, including the possible loss of principal.
Carefully consider a Fund’s investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Fund’s prospectus, which may be obtained by clicking here or calling 800 523-1918. Investors should read the prospectus carefully before investing.
Article is for informational purposes only and not meant to predict actual results. Information should not be construed as financial advice.
The Funds are distributed by Delaware Distributors, L.P., an affiliate of DMHI, and MGL.
(4592) July 2009
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