P/E Ratio

Introduction

What is the P/E ratio? It stands for price-to-earnings ratio, and it is one of the most commonly used ratios in investing. It takes the price for each share and divides it by the earnings per share (EPS) of the company. For example, let’s say that an imaginary company has an EPS of 6 and each share costs 12 dollars. The P/E ratio would then be 12 / 6 = 2.

Interpretation

What does this number mean, exactly? The P/E ratio tells you how much you would have to pay for each dollar that the company earns in profit. For the P/E ratio that we calculated earlier, this would mean that if you wanted to buy shares of this company, you would have to pay 2 dollars for every 1 dollar of profit that the company makes.

Valuation

The P/E ratio is one of the most common ways to value a stock. The valuation of a stock is how much the stock actually is worth. It is valued fairly if most people believe that the stock's price is where it should be based on how well the company is doing.

A stock is undervalued if most people believe that the company is doing better than the stock price indicates. In other words, the stock is cheap. This is usually the best time to buy.

A stock is overvalued if most people believe that the company is doing worse than the price indicates. In other words, the stock is too expensive. Valuation is a very complicated idea, so check out my article on it for more details here.

Usage

The P/E ratio indicates the valuation of a stock based on others in its industry. A high P/E ratio generally means the stock is overvalued. If we look at the interpretation, a high P/E ratio would mean that we have to pay a lot of money for each dollar of profit that the company earns, which isn’t very good because it could mean that we are paying too much for a company that isn’t making as much money as we would like it too.

On the flip side, a low P/E ratio generally means the stock is undervalued. Using the interpretation, we would pay very little money for each dollar of profit earned by the company, which is good since it means we are getting a good deal.

But what is a high or low P/E value? This depends on the industry, so always do your research. As a general rule-of-thumb, though, an average P/E ratio is between 10-20.

Warning

Never base your decision solely on the P/E ratio. It may be tempting to just buy stocks with low P/E ratios because it means you are buying them at a good deal. However, the P/E

ratio doesn’t tell the whole story. A high P/E ratio could mean that investors think that the company has a lot of potential to grow, so they are willing to pay high prices in the hope that the price climbs even higher. The P/E ratio is a good metric to use, but always use other ratios and do a lot of research to get the complete picture.