P/E Ratio Analysis: Digging Deep to Find the Real Answers

The p/e ratio is the price to earnings ratio. As you might imagine, price to earnings ratio is equivalent to the calculation of taking the asset price and dividing that by the earnings per share value. This would invariably equal to what is commonly referred to as the p/e ratio. The fundamental factors which the p/e ratio are tied to include the following:

Inflation Rate

Simply put, the higher the inflation rate, the lower the p/e ratios will be. This is commonly known as p/e contraction. The opposite can also be true for times of stable economic growth. In other words, during normal growth cycles the markets would experience p/e expansion on a global level. That's not to say that a single stock would experience the same p/e contraction just because the overall economy is experiencing high inflation. That's also not to say that that single would experience the same p/e contraction just because the overall stock market averages are experiencing those trends.

Internal company performance

That leads to the internal company performance. A great recent example would be the major internet companies. Take Google, for instance, they had experienced stellar growth internally and were not so much effected by the financial meltdown in credit because they were practically one hundred percent liquid. With this good performance and unabated strength financially speaking they were able to maintain their higher than average p/e ratio. That leads us to the industry performance and how that is tied to the p/e ratios.

Exogenous industry performance

We mentioned that Google had experienced good growth. Conversely, look at oil company,British Petroleum which may have experienced good growth as well. However, no matter how well they did, the industry itself was under major pressures. Therefore, the single stock had to experience major p/e contraction due to this industry pressure.

We must also take into account the fact that p/e ratio can be altered or manipulated based on the price maniuplation in the market as well as the internal managerial manipulation of earnings per share. To avoid ensuing conflicts from these obvious manipulations in the markets one should do their due diligence and consider alternative calculations for p/e ratios.

When calculating the p/e ratio there are certain alternatives that work better than simply taking the current price and dividing that by the current earnings per share. Consider taking an average price as the numerator and dividing that by operating income per share or some other gross profit measure for the denominator. If that is not enough you may even be bold enough to take an industry p/e ratio; which, invariably, would average out any of the internal manipulations that could appear for a single stock.

Those are some of the factors that analysts take into account in order to analyze the why's and the how's for what makes logical sense for a single stock's p/e ratio. Also, keep in mind that there may be irrational, major skews in this ratio during the normal course of a bull cycle.

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