PE Ratio: A stock’s “bang for your buck” ratio

I’ve decided to sell one of my businesses: It earned $1,000 last year. Not too shabby for my first startup. If you’re interested, the price tag is $850,000…cash.

Wanna buy it? Come on, you know you want to! ChubbyGrub’s freaking awesome! It’s been featured in Lifehacker! CNBC even did a story on it.

If you’re smart, you’d probably say no. You might even curse my children’s children for trying to rip you off.

The stock market is no different. Your God-given common sense can be applied to investing. To buy a share in Google is to literally own a piece of Google, so it’s important to at least know what you’re getting for your money.

That’s where PE Ratio comes in. The PE (or price-to-earnings) ratio is useful for determining how cheap a company is relative to how much they earn. Think of it as the “bang for your buck” ratio.

PE Ratio equals the price of a company divided by how much it makes in a year. Let’s say there’s a business earning $1/year, and the price tag for it is $20. For comparison’s sake, a different company made $2500/year and is worth $50,000. Both companies have a price to earnings ratio of 20 (50,000/2,500 = 20/1 = 20). If you bought either company, you’d be getting equal bang ($1) for how much you pay ($20)…the latter is simply making more.

Remember the ChubbyGrub example above? Scroll back to the top and calculate its PE ratio…don’t worry, I’ll wait.

The Answer: 850…

In other words, ChubbyGrub’s price to earnings is roughly the same as LinkedIn!

Things to remember:

  1. The lower the PE Ratio, the cheaper the stock.
  2. Do your homework. Cheaper stocks aren’t necessarily better, they’re just cheaper. PE Ratio is a good starting point, but it’s not the end-all-be-all.
  3. LinkedIn is insanely expensive!! Bubble? Absolutely.

PS No, ChubbyGrub isn’t for sale :)