PE RATIO, PE-RATIO

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Stock Trading 101 Click Here to Return to Part One

PE Ratio:  Stock Trading Course Part Five describes the PE Ratio Expansion Principle.

A part of fundamental analysis is understanding that as a stocks earnings rise the potential for stock growth increases.

PE Ratio or Price Earnings Ratio:  Stock Trading Part Five:

PE Ratio Expansion Principle:  Price Earnings Ratio Expansion Principle
The pe ratio or price earnings ratio expands in proportion to the price of the stock, given the earnings remain unchanged.

The pe ratio or price earnings ratio is a broad measure of investor's optimism for stocks. As investors become more optimistic about the future of a company, the price-earnings ratios may increase. This means that the price of the stock is growing faster than the company's earnings.

In 1996 Dell's average annual PE ratio was 12.6. A year later investors began to comprehend the growth that Dell was experiencing and were willing to pay a higher stock price relative to the average annual PE ratio of 26.8.(Value Line) The price of Dell Computer stock more than doubled by PE ratio or price earnings ratio expansion alone.

The following stock chart represents the fundamental analysis of pe ratio expansion

Let's look at an example to understand the pe ratio or price earnings ratio Expansion Principle:
Given Company XYZ
Price of $10.00 per share
Earnings of $1.00 per share
A company with a share price of $10.00 and earnings of $1 per share has a PE ratio of 10. The company suddenly makes an announcement that they have discovered a cure for cancer. Investors become more optimistic and willing to pay a higher stock price relative to the current earnings of the company. In other words a higher PE ratio or Price Earnings Ratio for the company. Investors pile into the stock driving the price from $10 to $20 per share. The resulting PE ratio or Price Earnings Ratio is the price of the stock, $20, divided by the earnings or $1 or 20.

The combination of the Earnings Growth Principle and PE ratio or Price Earnings Ratio Expansion Principle can have a powerful effect. If earnings double and the PE ratio or Price Earnings Ratio doubles then the stock price quadruples. For example, a company with a stock price of $10 per share, doubles it's earnings during the year and investor optimism balloons resulting in the PE ratio or Price Earnings Ratio also doubling. The end result is the price of the stock will be $40 per share.
From 1996 to 1997, Dell's earnings nearly doubled and the PE ratio or Price Earnings Ratio more than doubled. The combination of earnings growth and PE ratio or price earnings ratio expansion quadrupled Dell's share price.

The combination can also have a detrimental effect. Falling PE ratio or Price Earnings Ratio combined with falling earnings can drag a stock through the trenches of a falling stock chart.

Even great stocks rise and fall. Dell's stock did not always rise in the decade of 1990's. During the early 1990's Dell experienced growing pains and an inventory correction. Dell's stock fell from a high of $49.875 in January of 1993 to $14.625 in July of 1993 (not adjusted for splits). That was a 71% drop. The percentage drop may sound familiar to today's technology investor. Michael Dell describes the issue in his book "Direct from Dell", "Inventory is the worst thing to own in an industry in which the value of materials or information declines quickly, which today means any industry-from computers, to airlines, to fashion." And "We had to sell off that inventory, which depressed our earnings to the point where the company earned only a penny per share in one quarter."

PE Ratio Stock Trading Key Terms:  
PE Ratio: The ratio of stock price divided by earnings per share 
Price Earnings Ratio: The ratio of stock price divided by earnings per share
PE ratio or Price Earnings Ratio Expansion Principle:  The combination of increasing earnings and investor optimism can have a dramatic effect on stock price.

Stock Trading Part Three Quiz:

1. Dell Computer stock success was assisted by?
   a. A falling PE ratio and falling earnings
   b. A rising PE ratio combined with increasing earnings
   c. Rising earnings and falling PE ratio
2. A stock is priced at $10.00 per share, and a PE ratio of 10 at the beginning of the year.  Earnings double by the end of the year and investor optimism causes the PE ratio to reach 30 by the end of the year.  What is the resulting stock price?
   a. $20
   b. $30 
   c. $60

3.  A stock is priced at $100 per share and a PE ratio of 100 at the beginning of the year.  Earnings are cut in half by the end of the year and investor optimism causes the PE ratio to fall to 20, What is the resulting stock price?
   a. $10
   b. $50
   c. $75
   
   Answers to Stock Trading Part Four Quiz, 1. b, 2.c, 3. c