Understanding P/E Ratios

Many people are uncomfortable with the unfamiliar and math. They are more comfortable with the things they know. Price earnings ratios are a way to measure whether a stock is a value or not but many people are uncomfortable with the math of it. We recently presented the concept of equating the price earnings (P/E) ratio to interest rates.

Most people know about high and low interest rates because they buy certificates of deposit (CD). They liked 8% better than 3%. P/E ratios are the inverse of an earnings yield that is calculated by dividing the P/E ratio into 1. An example P/E of 20, divide 20 into 1 and you get 5%. In a P/E of 10, divide 10 in to 1 to get 10%. If the P/E is 50, it equals 2%. Who would want a 2% yield for any length of time?

Low yields are yields to be traded rather than held long-term. Too high of a yield could be a sign of trouble and should be researched as to why it is high. lf you have problems understanding P/Es and value, try thinking in interest rate terms.