Log on to any finance website to grab a price quote for your favorite stock and you’ll be bombarded with many other numbers. For most beginning investors these numbers are complex and confusing. With this series of posts I hope to change that. Today we start with the P/E Ratio.
One of the easiest, and most common ways to value a stock is through the Price/Earnings (P/E) ratio.
The P/E Ratio is simply, the ratio between a company’s share price and its earnings per share (EPS). So if a company’s stock sells for $10 per share and it has an EPS of 2, the P/E Ratio is 5 for that stock.
P/E Ratio = Price per share/Earnings per share(EPS)
Because P/E is one of the most common numbers investors look at, you’ll usually see it right along with the stock price on any website. So there is no need to manually calculate it.
Generally speaking, a stock with a higher P/E ratio is more “expensive” than one with a low P/E. This is because on the high P/E stock investors are paying more money for each dollar of earnings. As you can see in the picture above, Apple, with a P/E Ratio of 17.29 means that investors are paying $17.29 for every $1 of Apple’s earnings.
Why are investors willing to pay a premium on a companies earnings like this? Well, that leads us into one of the problems with using P/E Ratio (or any single metric) to solely value a stock. P/E Ratio is really more of a historical tool than an indicator of future growth. The earnings used in the calculation come from the previous 4 quarters of performance, while most investors are more interested in what the stock will earn going forward.
P/E Ratio is useful to get a very general feel for how good of a value a stock may be. A $10 stock with a P/E of 30 is much more “expensive” than a $100 stock with a P/E of 5.
As I mentioned before, your investing decisions should never be based on one number alone. It’s important to understand the company you are researching, get a feel for its past performance, future outlook and how it stacks up against the competitors in its industry.
The average P/E ratio of the market is between 15-25 so, stocks trading on the low-end of this may be good values while stocks above the top range may be trading at too steep of a price.
P/E Ratio may be a good place to look to start some initial research into a company, but its only one weapon in your arsenal and much more analysis should be done before actually buying shares.