In a previous article, we explored earnings, why they’re important to us as investors, and learned how to calculate EPS (earnings per share). In summary, EPS is simply a way to express a company’s earnings in a manner that is independent of the number of shares outstanding. This allows us to do some pretty useful comparisons between companies, especially when we introduce the PE ratio (Price / Earnings ratio).
We’re going to look at how we can use PE ratios to determine whether a stock is expensive, cheap, or priced comparatively to its peers. But first, let’s look at how businesses are priced in a bit more detail. To do this, let’s look at a fictitious company, XYZ which had earnings (profit) of $10,000 last year. Let’s ignore the value of the company’s assets for a moment and assume they’re zero. How much is XYZ worth? Continue reading