P/E PRICE TO EARNINGS RATIO

If the earnings per share is the fundamental measure of how well a company is performing, then the price to earnings ratio, or P/E, is the fundamental measure of how over- or under-valued a stock is. The P/E is derived by simply dividing a company’s stock price by their EPS.

For example, if a company has annual earnings in 2009 of $45 million, and there are one million outstanding shares, then the company has an EPS of $45. If the stock is currently selling for $38, then we divide $38 by $45, and get a P/E of 0.844. If, on the other hand, the stock was selling for $52, the P/E is 1.155. In the first case, with a number less than 1, we can expect the stock price to increase over time. In the latter case, we can expect the stock price to decrease. A core principle of fundamental analysis for binary options, in fact, is that the P/E of a stock will tend to approach 1, unless other fundamental factors prevent that from happening.

In fundamental analysis, two types of P/E are generally looked at: prospective P/E and historical P/E. Prospective P/E looks to the future by examining company or analyst predictions for EPS, while historical P/E looks at past EPS and past stock price.

For example, a binary option trader might see analyst earnings predictions that average $51 million in 2010 for a company with one million shares of outstanding stock. This would give the company a prospective EPS of $51, and the option trader would choose to purchase the stock at any price less than that. Looking at historical P/E, on the other hand, can give a feel for whether a company tends to be undervalued by investors or overvalued, which indicates how reliable the company’s market valuation is in the short term.