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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.
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:
- 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.