Want to know the secret formula for stocks? The P/E (price-to-earnings ratio) is a metric different analysts and investors use when determining stock valuation. Not only does it reflect whether the stock price of a company is undervalued or overvalued but also reveals how a stock valuation compares to an industry group.
That is to say, the P/E ratio is extremely helpful for investors to determine the market value of their stock when they compare it with the company’s profit. It is a simple and easy way to determine how much the current market can pay for a stock for its future earnings.
For example, if your company has a high P/E value, it can translate into overvalued or high stock prices in terms of earnings and profits. Conversely, if the company has low P/E value, it’s an indication that the stock prices are low or undervalued in terms of earnings.
Interestingly, firms with a high growth rate as compared to average companies typically show a higher P/E ratio. A number of technology companies show a high P/E ratio, which means many investors tend to pay a good share price seeing the growth expectations and opportunities in the future.
For example, if your company’s current P/E ratio is 25 (above the S&P average), its trades have 25 times greater earnings. This high value indicates that shareholders expect a higher growth from your company as compared to the overall market. However, the high P/E ratio does not necessarily indicate that your stock or share is overvalued. You need to consider the P/E ratio against the P/Es of the backdrop of a specific company’s industry.
That means, determining P/E ratio can undeniably be useful. Plus, as an investor, you can rely on it to explore whether your company’s stock will be expensive or not. However, there are certain limitations when applying the P/E ratio, partly because of accounting rules and partly because of inaccurate estimations investors make when predicting growth rates.
Regardless of these flaws, P/E ratio is a great method you need to know when choosing value stocks and here is how you can do that.
Why Do You Need P/E Ratio as an Investor?
As an investor, before you make the most of P/E ratio for your various investing activities, understanding how it works is really important. To put it simply, P/E ratio is the price you are paying for $1 of a company’s profit. If the company is making diluted earnings of $2 per share and its stock is selling $20 per share, you can easily find out the P/E ratio by dividing per-share earnings with diluted earnings of the company, i.e. 20/2 = 10 P/E.
Many finance experts consider it useful because this method can help investors calculate earnings yields on stocks. It allows investors to compare their profit returns from business investments that include bonds, notes, treasury bills, certificate deposits, and real estate. However, if you use your diligence to keep your investment safe from value traps, it becomes easy to view your portfolio individually and as a whole. With this lens, you can avoid being swept away in panics, bubble, and manias.
P/E ratio provides you enough margins to assess the stock market and help you focus on the hidden economic reality. No matter if you are an apprentice when it comes to making investment decisions, there are stock market and financial portals that automatically determine the price-to-earnings ratio for any company. Once you find out the P/E ratio, it is the right time to wield its power.
It is great to differentiate between stocks that apparently have a high selling value due to the trend among analysts and a famous company that has somehow fallen out from the stock market and is selling its shares for a fraction.
Understanding P/E Ratio by Industry
To become a pro investor, it’s essential to understand that every industry has different price-to-earnings ratios. That means different industries consider different P/E ratio as their normal range. For instance, a technology company can sell an average P/E ratio of 30. A textile manufacturing company, on the other hand, may have an average trade P/E ratio of 20. In short, when it comes to measuring P/E ratios, there can be exceptions and variance between industries and sectors, which is acceptable.
How to Calculate the P/E Ratio
As mentioned earlier, calculating P/E ratio is easy. All you need is to divide the market value of per share by per share earnings of the company.
Earnings per share refer to the amount of profit a company allocates to each separate share of its common stock. These shares serve as an indicator of the financial health of the company. Precisely, earnings per share are the specific portion of a net income that the company will earn if they divide the profit equally among all the shareholders. Many traders and analysts use it to establish a company’s financial strength.
Here’s the formulae you can use:
Price-earnings Ratio = per share market value / per share earning
For instance, the EPS of Bank of America (BFA) at the end of the year was $2.61 and its share price was $24.57. Let’s estimate the P/E ratio:
P/E Ratio = 24.57/2.61 = 9.41
That means BFA traded at nine times better earnings. However, P/E 9.41 is not helpful if you don’t have other values or metrics to compare it with. You can compare it with the stocks from the same industry group or any other benchmark index. Comparing P/E ratio with market competitors is not only beneficial but also necessary to see its financial status. If the BFA P/E ratio is greater than its peer banks in the market, it doesn’t make it undervalued.
Overall, the P/E ratio is now widely used by traders and investors to estimate the stock price of the company and its earnings. This method is not only popular but is also easy to calculate. However, while determining a stock valuation, investors should consider its shortcomings and limitations to improve future earnings growth. This is one of our secret formulas for stocks.