Why is the price earnings ratio so important?

Price-Earnings ratio or PE Ratios are calculated only for common stocks and not for preferred. The only relevance earnings have to most preferred shareholders is how well (or by what safety margin) they cover preferred dividends – and the “preferred dividend coverage ratio” measures this best.

Current market price of common/Earnings per share (in latest 12-month period) The main reason for calculating earnings per common share – apart from indicating dividend protection – is to enable a comparison with the share’s market price. The PE ratio expresses this comparison in one convenient figure. It’s a short way of saying that a share is selling at so many times its actual or anticipated annual earnings. PE ratios enable one share to be compared with another. Example Company A - Earnings per share: $2; Price: $20 Company B - Earnings per share: $1; Price: $10 Though earnings per share of Company A ($2) are twice those of Company B ($1), the shares of each company represent equivalent value because A’s shares, at $20 each, cost twice as much as B’s. In other words, both companies have a PE ratio of 10:1 (or are selling at 10 times earnings) – Company A, $20/$2; Company B $10/$1. PE ratios reflect the views of thousands of investors on the quality of an issue. The elements that determine the quality of an issue – and therefore are presented in the PE ratio – are:

• Tangible factors contained in financial data, which can be expressed in ratios relating to liquidity, earnings trend, profitability, dividend payout and financial strength.
• Intangible factors such as quality of management, nature and prospects for the industry in which the issuing company operates, competitive position and individual prospects or the company. All these factors are taken into account when investors and speculators collectively (and subconsciously) decide what price a share is worth in terms of the number of times its earnings are expressed in its price.

To rate the PE ratio for one company’s common with others, the companies must be comparable, which usually means they must be in the same industry. In the example, price-earnings ratios are calculated on a company’s earnings in the latest fiscal year. In practice, however, most investment analysts and firms make their own “projections” of a company’s earnings for the next twelve-month period and calculate PE ratios on these projected figures in terms of the stock’s current market price. The PE ratio is probably the most useful and widely used financial ratio because it is, in fact, all the other ratios combined into one figure. It represents the ultimate evaluation of a company and its shares by the investing public.