There are many metrics that help investors choose which stocks to invest in. One of the most important metrics that one can use to assess the potential of a stock is the price-to-earnings ratio (P/E ratio).
The price-to-earnings ratio (P/E ratio) is the ratio of a company's share price to the company's earnings per share. The equation goes as following: P/E = share price / earnings per share.
You simply take the price that the stock is currently trading at and divide it by the company's earnings per 1 share.
The market price per share is the current price at which the stock is trading at.
The earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock, usually calculated on a quarterly or annual basis.
Let's look at an example.
If Company X is being publicly traded on the NYSE at a share price of $50, and the company profits off of each share with an EPS of $5, then the P/E Ratio would be $50/$5 = 10. This essentially means that investors are willing to pay $10 for every $1 in earnings that the company makes.
Trailing P/E Ratios
This ratio is based on the company's earnings over the past 12 months. It uses historical data and is often referred to as the current P/E ratio. This is a great metric for us to use to evaluate a stock.
Forward P/E Ratios
This ratio is based on projected earnings for the next 12 months. It uses estimated future earnings, providing insight into how the market expects the company to perform in the future.
Why is the P/E Ratio significant?
1.) Valuation - The P/E ratio helps investors determine whether a stock is overvalued, undervalued, or fairly valued compared to its historical P/E ratio, the P/E ratios of competitors, and the overall market.
2.) Investment Decisions - A high P/E ratio might indicate that a stock is overvalued or that investors expect high growth rates in the future. Conversely, a low P/E ratio might suggest that a stock is undervalued or that the company is experiencing difficulties.
3.) Growth Expectations - The P/E ratio reflects market expectations about a company's future growth. Companies with higher growth potential often have higher P/E ratios because investors are willing to pay a premium for expected future earnings.
High Overvalued P/E Ratio vs. Low Undervalued P/E Ratio
High Overvalued P/E Ratio
Company A
Current Stock Price: $200
Earnings per Share (EPS): $5
P/E Ratio: 40
A P/E ratio of 40 is high compared to the market average (15-25). Investors are paying $40 for every $1 of earnings.
Reasons for a High P/E Ratio:
Growth Expectations: Rapid industry growth with expected earnings increases.
Market Hype: Recent breakthroughs or new product launches.
Market Sentiment: High potential perceived in the tech sector.
Risks:
Overvaluation: If future earnings don't meet expectations, the stock price could drop.
Market Correction: Overvalued stocks are vulnerable to market corrections.
Low Undervalued P/E Ratio
Company B
Current Stock Price: $50
Earnings per Share (EPS): $100
P/E Ratio: 0.5
A P/E ratio of 0.50 is low compared to the market average. Investors are paying $0.50 for every $1 of earnings.
Reasons for a Low P/E Ratio:
Slow Growth: Operating in a mature industry with limited growth prospects.
Economic Challenges: Facing economic or operational challenges.
Market Sentiment: Negative sentiment around the industry or company.
A high P/E ratio often suggests that a stock is overvalued due to high growth expectations or market hype, while a low P/E ratio may indicate that a stock is undervalued due to overlooked potential or current challenges. Investors should consider these major factors affecting the P/E ratio and use them alongside other metrics to make smart investment decisions before buying new stocks. The P/E ratio can save investors so much time and money by informing them of the value and volatility of a stock.
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