More on the P/E Ratio

                                                             
     One way I use the P/E ratio is to try to predict the future price of a stock. Lets say one company- XYZ corp. is trading at only 8 times earnings. Research shows other companies in this industry are trading at 14 times earnings. A little research shows that XYZ had a really bad quarter due to a bone-headed restructuring kind of like what happened to J.C Penny store. Suddenly, the board of directors got fed up and fired the CEO who created the mess. The new CEO restored order and people slowly returned to Pennys for their clothing needs. The old ratio looked like this P/E=Xm where stock price over earnings = a multiple of 8. I'll make up some numbers to fit, 16/2=8 where the stock was trading at 16 and the annual earnings was $2 which results in a multiple of 8X. Now that things have turned around for Pennys, I expect that their multiple will approach the industry norm. A little algebra will show that a multiple of 14X for Pennys will result in a stock price of  $32. X/2=16, solving for X yields the $32 stock price. Now this is very simplistic because it  doesn't take into account higher earnings due to the turnaround. Let's say the earnings increased to $3 in the year of the turnaround. Then a stock price of $48 could be expected. X/3=16- solving for X results in the $48 stock price. Notice that we are talking about comparing a company with peers in the same industry. My next discussion will allow us to compare valuations in different sectors which are growing at different rates. This is achieved with the PEG ratio which is the PE/growth comparison.





























xyz