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Lemonade Stand Part Four: Price to Earnings Ratio



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I know the image doesn’t say the words Earnings anywhere. As an investor, you look at the value of the company. The company’s value is based on their Earnings. And that is why it says value and is still related to P/E Ratios.
The first thing you need to know about P/E Ratios is what P and E stand for. P stands for Price and E for Earnings. Therefore, P/E is a Price to Earnings Ratio or to put it in another way, Price divided Earnings. A P/E Ratio calculates how much you will have to pay to get a dollar of the company’s earnings. If Mattel’s(MAT) P/E Ratio is 31.3 that would mean when you pay $31.30 you would get a dollar of Mattel’s earnings.

Here’s how to calculate it. As the metric clearly states in the name you divide the company’s Price share by their Earnings per share. I use Morningstar for my stock research. First, you need to find the Earnings per Share, that is located on the Key Ratios page. Mattel’s Earnings per share is $1.02 and their Price per share is $31.97, you should be able to find that on the page titled Quote. When you divide the two numbers, 31.97 / 1.02. You get 31.3, that would be their P/E Ratio. As a stockholder, you want the lowest P/E Ratio. The reason you want the smallest P/E Ratio possible is so you pay the smallest amount to get a dollar of the company’s earnings.   Although this is one of the more simple metrics it is very important and can be hard to understand.

Although you like to know how much you’re paying for a share in a company you want to know how much bang for your buck you get. And that’s what the P/E Ratio shows. Again, it shows how much you need to pay to get a dollar of the company’s profit.

If we look at Hasbro and Mattel, they both do similar things but their P/E Ratios are so different. Mattel’s as we know is 31.30 and Hasbro’s is 21. Although when you look at the Prices Mattel’s seems like a much better deal, $31.97 versus $80.16. But, when you dig deeper you can tell that to pay only $21 you get a dollar of Hasbro’s earnings whereas you have to pay $31.30 to get a dollar of Mattel’s.  

Companies
P/E Ratio
Mattel
31.30
Hasbro (Winner-lower P/E Ratio)
21


On the Quote page of Morningstar, they show the forward P/E, that is different than the current P/E. Forward P/E is the predicted P/E for the company in the next year coming up, and the P/E is the current P/E for the last twelve months. We want to use the current P/E. Mattel for example, has a forward P/E of 17.5 and a current P/E of 31.3. Not only are the numbers different, but what they are showing. As most predictions are, the forward P/E Ratio is a guess. The CEO/CFO is guessing what their earnings will be which will affect their stock price which will then affect their P/E Ratio. All in all, it’s a big guessing game, some years it could be right and other maybe not. That is why the current P/E Ratio is more reliable, it is all the information that they have making it true.

Last but not least, we will use a Lemonade story to go over the calculations in a simpler way.
Lily and Sara were sitting waiting for their customers when Kristin ran over.
“Girls,” she said, “all my friends have been asking me what the price to earnings ratio is for your lemonade stand and I don’t know how to calculate it.”
“Mom we learned this ages ago,” said Sara.
“You take the price of the share, in our case, it’s $2.00, and divide that by our earnings per share, which is $0.40. That would give you five.” Lily said.
“Five what?” Asked their confused mother.
“Just five,” Sara said, “It’s a ratio so it’s not a percentage nor is it an amount of money.”
“Thank you, girls, now I know what to tell my friends!”

It’s pretty self-explanatory, it’s said in the name. Of course, you do still have to think about it. One more thing, P/E Ratios change as does the information that you need to calculate the Ratio. Like other metrics for stocks, you want to watch it and sell at a high and buy at a low.

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