Why To Care About the P/E Ratio

The PE ratio is the most common measure of how expensive a stock is.

One of the first things to consider when considering investing in any particular stock is the stock’s PE ratio.  The price-to-earnings (“PE”) ratio helps investors value a stock when comparing the price to the amount the company earns per share.  The PE ratio alone is not all a potential investor needs to look at to determine if a stock is a good buy.  Fundamentals of a company are also very important.  However, determining whether the PE ratio is too high is very important if you want to avoid the risk of buying an overvalued stock.

Overvalued or Undervalued?

To help determine whether a stock is overvalued or undervalued, we need to look at the PE ratio formula.  PE ratio = Market Price / Earnings Per Share.  Therefore, the higher the PE ratio, the more speculative value is in the company.  Basically, the PE ratio shows what the market will pay for a stock of the company based on its current earnings.  The PE ratio often helps investors to determine whether they think the companies future earnings per share will increase or decrease.  This prediction based on the history of a company’s PE ratio helps either increase or retract the stock’s price.

The P/E ratio can easily be calculated at the end of each quarter using a company’s financial statement (as that is when you will learn of the company’s earnings per share).  GE may not be a good example because of all the terror it has struck into the hearts of its investors recently.  However, GE is currently trading with a PE ratio of 24.58, which is one of the lowest GE has traded in at least two years.  This drop in the PE ratio has drawn some investors eyes to hope that the storm has cleared and GE’s new price has finally settled.  The PE ratio can also be used as a tool to determine how a company’s stock price is expected to rise.

PE Ratios Can Predict Rises in Stock Price

The Price-to-earnings ratio provides the price of a share based on the amount of its earnings.  If the amount of the earnings increase, the stock price should rise to meet the earnings bump.  Therefore, an higher earnings should result in a higher market value per share.  Typically, companies with higher PE ratios tend to indicate positive expected future performance.  Meanwhile, companies with lower PE ratios low expected future performance and current performance.  Other reasons for a lower PE ratio is that the stock is undervalued or that the company is doing exceptionally well compared with its performance history.

Example:  If there is a company worth $10 with earnings per share of $1, then the PE ratio is 10.  This means that investors are willing to pay $10 for every $1 the company earns.  If investors keep the same mindset with the company, but the earnings per share rise up to $1.20 per share… The prediction would be that the market value of the share would be $12!  If the investors expect the earnings per share will continue to rise at an accelerated pace, then the PE ratio would likely go higher.  This would increase the market value of the stock and is an opportunity to reap some major profit.

Compare in the Same Industry!

The PE ratio should be used as a valuation metric when analyzing similar companies that are the same size and in the same sector.  It can also be used when analyzing a company with its past valuation.  When similar companies have a very different PE ratio, there is likely to be a problem somewhere.

If a company has a high PE ratio compared to historical levels, it may be a sign of the shares being overvalued.  However, there may be some rational explanation.

Don’t Just Use the PE Ratio

Do not stick to one theory unless you can relate needed factors into your analysis.  Just because a stock is VERY undervalued does not mean it is a good deal.  Purchasing a great stock that is overvalued makes no sense either.  You need to look to the stock’s fundamentals and you need to find a stock that is a value stock.  A value stock means that it is being bought at a bargain.  That’s what everyone wants.

Price-to-earnings should never be the sole factor in valuing a company because earnings are fluid and can change due to a variety of circumstances.  A company with a PE of 10 is not always a better investment than a company with a PE of 50.  Sometimes there are good reasons for a P/E to be high or low.  The trick to investing wisely is knowing when the market has it right and when it has it wrong.

What To Look For

What I enjoy holding is a quality company with good fundamentals that has a lower PE ratio while also being a dividend stock.  I will explain this tactic later, but reinvesting dividends into your stocks can be very profitable with a quality company.  These kinds of wealth building tactics can bring you to earning passive income through the dividends and through value gain.  If you are interested, check out my former post about a famous dividend stock that with potential to rise.

In Conclusion

The PE Ratio is an indicator of how much premium the market is putting over a stock in comparison to other similar stocks.  If we find two similar businesses of equal quality, the stock with a lower PE ratio is the better value.  Value is what investors go after.  Another way to look at it is that the PE ratio is an investor sentiment indicator.  It indicates whether or not the investors in the market think the stock is going to outperform or underperform.  When PE goes up, it shows that current investor sentiment is that the company is worth more, its future prospects are bright, and sellers are only giving up their stock at higher prices.  A dropping PE is an indication that the company is out of favor with investors.

An investor should focus on trying to find a company that is performing well, but under their big competitors price-to-earnings.  The more investing knowledge in your toolkit, the better prepared you will be to trade.  Get it right more than you get it wrong.  Aim for more money every day, and get your investments rolling!

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