P/E ratio helps investors analyze how much they should pay for a stock on the basis of its current earnings.
It also shows if the company is overvalued or undervalued by the market.
An earnings report tells you how a company is performing. But the P/E ratio tells you how investors think the company is performing.
You can see the P/E ratio in the details page of a stock. If you put a search for a particular stock in Google or Yahoo finance website, you can see the P/E ratio there.
A good P/E ratio in one industry can be bad in another. If you’re looking for a value stock, you want the P/E ratio to be low. The opposite is actually true for growth stock.
If a company has high earnings, it’s likely a lot of investors will want to buy its stock.
Even though the P/E ratio is useful, but don’t rely only on this ratio for your stock purchase decisions.
The P/E ratio is a measure on how well a stock’s price is doing relative to the company’s earnings.
The P/E ratio can also help you to tell whether the stock price is high or low, compared to other companies in the same sector.
P/E ratio = price per share ÷ earnings per share
The EPS (Earnings per share) estimate is critical for determining whether the stock is reasonably priced.
Let’s say a company is reporting earnings per share (EPS) of $2, and the stock is selling for $40 per share. In that case, the P/E ratio is 20
Because $40 per share ÷ $2 earnings per share is the P/E ratio.
For example, In the software sector, companies often have higher growth rates and higher returns on equity. That means they can sell at larger P/E ratios.
(Return on equity (ROE) is referred to as stockholder’s Return on investment. It reveals the rate at which shareholders earn income on their shares.)
On the other hand, in the banking sector, companies tends to have a lower P/E ratio.
So, it depends on the sector.
If you think a company has a superior business but it still has a low P/E ratio, then it may be a good investment.
Not only you can use the P/E ratio to know which sectors are overpriced or underpriced, you can also compare the prices of different companies within the same sectors.
For instance, if two companies, Apple and Xerox, are both selling for $50 per share, one might be far more expensive than the other. This depends on the profits and growth rates of each stock.
Suppose Apple reported earnings of $10 per share, and Xerox reported earnings of $20 per share. Apple has a P/E ratio of 5, while Xerox has a P/E ratio of 2.5.
Xerox is a better purchase at that time, because of the lower share price along with similar earnings. For each share purchased, you’re getting $20 of earnings from Xerox rather than $10 in earnings from Apple.
I think this gives a better understanding of the scenario.
If you are tempted to buy a stock because it has a good P/E ratio, be sure to do your research and figure out whether it’s truly as good as it seems.
A low P/E ratio is generally better than a high P/E ratio, that a company with a lot of cash on its balance sheet is superior to one burdened with debt, isn’t it?
Some experts suggest, it’s just not possible to check through every balance sheet to identify companies that have a favorable net debt position and are improving their net margins.
So, pick an industry that interests you, and explore the news and trends that drive it from day to day.
A smart stock picker is always aware of the daily news, trends, and events that drive the economy and every company in it.
It’s vital to keep up with market news and opinions. Reading the financial news and keeping up with industry blogs is a form of research.
Thank you for reading! In the next blog, I will discuss about the other ways of picking/choosing right stocks. Please check back on my website.