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1. What is P/E Ratio?
2. P/e Ratio Example
3. Advantages of P/E Ratio
4. Disadvantages of P/E Ratio
5. What is a Good P/E Ratio?
6. The Bottom Line: P/E Ratio

Let’s be honest: Picking a stock is hard.

There seems to be an endless list of stocks to choose from.

There are also different kinds of stock.

A stock quote can be difficult to read.

Throw in risk — the reality that you can lose your hard-earned money — and it can be a stressful experience for new and experienced investors alike.

Wouldn’t it be great if you could easily and quickly know if a stock is overvalued or undervalued at the moment?

You can with a P/E Ratio.

In this article, we’ll break down how you can use the P/E ratio to make choosing a stock — a stock that will lead to a profit — easier.

## What is P/E Ratio?

It can be difficult to compare the stocks of companies of different size, different business fundamentals, and more. That’s where the P/E ratio comes in.

Using a company’s earnings, the P/E ratio is most commonly used to judge whether a stock is:

• overvalued
• undervalued
• properly valued

A high or low p/e ratio can help you as an investor access the stock or company that you’re deciding on investing in.

P/E ratio is most commonly calculated using these two formulas:

### P/e Ratio Company Basis Formula

P/e = Market capitalization / Annual Net income

### P/E Ratio Per Share Basis Formula

P/e = Cost per share / Annual earnings per share

## P/e Ratio Example

Now that we’ve established what the P/E ratio is and how to calculate it, we’ll take you through a quick example.

Let’s say we’re taking a look at ABC company.

Their market capitalization is \$1 billion, and they’re expected to have \$50 million dollars of net income this year.

In this case, we would simply divide \$1 billion by \$50 million to get a P/E ratio of 20

Is this a good or bad P/E ratio? We’ll discuss this later on in the article.

Next, we’ll look at using the advantages and disadvantages of using the P/e ratio.

## Advantages of P/E Ratio

The main advantage of the P/E ratio is that it enables investors to quickly and easily compare the health of a company to its peers.

Looking at the P/E ratios of a pool of stocks within the same sector will quickly help you figure out which companies are overvalued, and which ones are undervalued, and worth doing some due diligence on.

## Disadvantages of P/E Ratio

Like with any ratio, there are disadvantages to keep in mind.

Using the p/e ratio formula requires using the earnings of a company. Compared to a stock price that fluctuates daily, these earnings are only released every quarter. A p/e ratio may not be a completely accurate representation of a company’s performance.

## What is a Good P/E Ratio?

### The Short Answer...

Generally speaking, a P/E ratio of somewhere near the market average — in the mid-20s — is considered “good”.

### The Long Answer...

A higher P/E ratio than the market average signifies that you’re paying more to purchase a share of the company’s earnings. On the other hand, this implies that investors are expecting the company to grow earnings faster in the future.

That’s why a lower P/e ratio can be considered better — but to a point. A negative P/e ratio means that a company is operating at a loss.

Also, keep in mind that p/e ratios will vary across stock sectors. For instance, growth companies, like Tesla and Square will have a much higher P/E ratio (usually in the hundreds) than an established banking stock, like JP Morgan, which will typically have a P/E ratio around 10.

High-growth, high-risk stocks will usually have a higher P/E ratio, whereas large, established, lower-risk companies will usually have a lower P/E ratio.

## The Bottom Line: P/E Ratio

The P/E ratio is an important tool an investor can have in their toolkit.

It’s a quick and easy way to compare stocks to one another and identify potential buying opportunities. It’s also a great tool to identify undervalued companies within a sector.

Knowing how to properly calculate and use the P/E ratio will help you make more educated decisions on the investments that you make, which can seriously pay off in both the short and long term.

But it’s not a complete answer for whether or not you should buy a particular stock. The complete answer lies in using stock investing fundamentals to help you choose the right stock.