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What Is The Price To Earnings Ratio And Why Is It Important?

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by Gavin in Blog
May 1, 2020 0 comments

Contents

Introduction

The Price to Earnings ratio is probably one of the most cited metrics of stocks.

Sometimes known as the earnings multiple or price multiple, the price to earnings ratio is used to get a quick glimpse of the current price of a stock, relative to its earnings per share.

This simple to calculate metric serves a couple of useful functions for investors, allowing them to make like-for-like comparisons of the relative value of different stocks, as well as to compare against historical norms to spot buying and selling opportunities.

Determining The Price To Earnings Ratio

Determining the Price to Earnings (P/E) ratio is relatively straightforward.

All you need to do is take the market value per share (i.e. the current stock price) and divide it by the earnings per share (EPS).

For example, if a stock cost $11 per share and has earnings of $0.85 earnings per share, its’ P/E ratio would be 12.9 ($11 / $0.85 = 12.9).

You can also find this number for free on most finance and stock market-related sites.

When calculating the P/E ratio or looking up the numbers online, be careful of variances in EPS.

While the price per share is always the same (i.e. it is the current stock price) the EPS value can represent either the earnings across the last 12 months (known as trailing twelve months, or TTM for short) or an earnings estimate based on a company’s latest earnings release.

The P/E ratio may be easy to calculate but don’t let that fool you into thinking it’s not worthwhile to keep an eye on.

There’s a reason it has been so popular over many, many decades.

The Value Of The P/E Ratio

The main benefit of the P/E ratio is that it helps investors identify whether a stock, industry or even entire market is potentially overvalued or undervalued.

When calculated, the P/E ratio provides investors with an indication of what they can expect to pay to get one dollar of a company’s earnings.

By comparing the P/E ratio between different stocks, industries, and markets, investors have a simple, yet effective like-for-like comparison.

We can demonstrate this through an example.

Say you were trying to decide between two stocks.

The first stock, ABC, currently trades at $14 a share.

The second stock, XYZ, currently trades at $7 a share.

If you looked at the price and nothing else, you might be fooled into thinking that XYZ is a better investment because it’s half the price of ABC.

But let’s see what happens when we work out the P/E ratio.

ABC has an EPS of $1.2 while XYZ has an EPS of $0.35.

ABC P/E ratio = $14 / $1.2 = 11.7

XYZ P/E ratio = $7 / $0.35 = 20

What the P/E ratios have shown, is that even though XYZ is trading at half the current price of ABC stock, you are paying almost double for equivalent earnings!

This makes XYZ a far costlier investment as you will be getting fewer earnings for your money.

There might be good reasons for this, such as a temporary drop in revenue or the expectation of high growth, but it serves as another useful tool in analyzing stocks.

In a similar vein, P/E ratios can be compared across industries and even across entire markets.

The P/E ratio of the S&P 500 has risen and fallen over time from extreme lows such as 7 in 1950, through to extreme highs such as 70 in 2009.

Generally, the long-term average P/E for the S&P 500 is about 16.

Using The P/E Ratio

As of writing, the P/E ratio of the S&P 500 is approximately 19 (TTM).

Compared to the long-term average of 16, this implies the market is currently more expensive than average, warranting further analysis before deploying capital.

In general, when a stock has a high P/E relative to others and/or the general market, it means that investors are expecting that stock to have higher earnings growth relative to other stocks.

Similarly, a low P/E may signify that a stock is undervalued or that earnings may decrease over time.

In all these cases, the P/E ratio is only suggesting or indicating that a stock is overvalued or undervalued.

No single metric is enough to accurately describe the fundamental performance of a stock, and the P/E ratio is no exception.

It works best when combined with other analysis or used as a ‘sense check’ against peers.

When using the P/E ratio, avoid comparisons between companies that aren’t similar in sector and style.

For example, one stock could have a higher P/E ratio than another stock, but the former may be a high growth technology stock while the latter is a slow-growing bank.

The technology stock is likely to have rapid growth in earnings as they can scale their products quickly, while the bank enjoys a slow, but steady earnings growth from writing home loans.

Finally, be aware that leverage can skew P/E ratios so review a company’s debt levels when a P/E ratio seems out of place relative to peers.

Conclusion

The P/E ratio reflects the amount of investment required to earn $1.

It is found by taking the price per share of a stock and dividing it by the stock’s earnings per share.

A high P/E ratio can signify that stocks are expensive or are expected to increase rapidly in earnings.

Likewise, a low P/E ratio can signify stocks are cheap or are expected to see a decrease in earnings.

To make the best use of the P/E ratio, be sure to use it with similar companies so that the different characteristics of different industries, such as fast-growing technology stocks vs slow-moving consumer staples, are not skewing your analysis.

Trade safe!

Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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