2. What is a P/E ratio?

We see the P/E ratio a lot in annual reports, on Bloomber terminals and websites... but what does actually mean, and how do people use them. The good news is that you never have to do the calculations because there are tons of websites to see them. However to really understand what P/E ratio is about, you need to see what it has inside. So, why do we use P/E ratio? In short, as an investor we want cheap shares, and we can use P/E ratio to determine if a company is cheap or expensive.

What is P/E ratio stand for? "P" is the price per share for a company at the moment, for example using yahoo finance and looking up Tesco we will get 4.20 $. "E" means Earnings per share (EPS), which is an accounting number that you can pick up from the balance sheet, and represents the profits per share. The EPS for TESCO is 30 $. Remember that we can´t compare apple with pears, so we have to use the same scale. That means if we are using Price per share, we have to keep on using Earning per shares, instead of market capitalization.

That gives as a result 0.14 or 14 times, sometimes is called multiple as well. This number means that if you are paying 4.20$ to get a share of Tesco, you are paying 14 times for 1 year's earning, so it´s going to take 14 years to get my money back if the earning don´t change. So should I buy it or not? The answer is it depends on your competitors, industry and market.

We find a company called Sainsbury has a ratio of 13. Sansbury is a bit cheaper, but the difference is still too small. I can look up the food retail sector in Bloomberg for instance, and let´s say that is trading on a P/E ratio multiple of 16. So it looks that these 2 companies are relatively cheap comparing with the sector, and Sansbury is cheaper than Tesco. However I can go further looking up the P/E with the rest of the market which has 17. So now I have to ask the question "why"? Is there a reason because Tesco and Sainsbury are cheaper?

Benjamin Graham, the legendary investor and Warren Buffett´s teacher at Columbia University said that stocks should trade for P/E multiple equal to 8.5 times plus two times the growth rate of earnings.

However it depends on the industry because some homebuilders and commodity producers tend to trade at low P/E multiples because earnings tumble in a hurry so investors don´t want to pay too dearly. However growing companies like Netflix, with a huge P/E of 382, or Facebook which is trading 222 times earnings, are valued much more on the hope future profits. Therefore the investors are willing to pay for a high P/E ratio when they expect a high growth in the company.