How Can I Use The P/E Ratio? – Napkin Finance

P/E Ratio

At Any Price

The price-to-earnings ratio (or P/E ratio) is a way to evaluate whether a company’s stock is cheap, expensive, or fairly priced given its current share price.

Just like a T-shirt could be cheap if you buy it at a discount store or expensive if you buy it at a high-end boutique, stocks can be cheap or expensive too. P/E ratios are the main tool investors use for assessing this.

Calculation

The P/E ratio compares a company’s stock price to its profits. It’s calculated with the following formula:

stock price / earnings per share

Said another way, it tells you how much you’re paying per dollar the company earns in profits (earnings per share is just a company’s total profits divided by its number of shares).

For example, if a company has a P/E ratio of 20, investors are willing to pay $20 for every dollar it earns in profit.

How used

P/E ratios are always used to judge how cheap or expensive a stock is. But just knowing that a stock has a P/E ratio of 20 doesn’t tell you this on its own.

Instead, investors typically compare different P/E ratios to determine whether a given stock (or group of stocks) is a good value at its current price. For example, investors may compare P/E ratios:

  • Of one stock with others in the same industry
  • Of one stock with its own historical average ratio
  • Of one industry with another industry
  • Of the whole market compared with the market’s historical average ratio

All else equal, a lower P/E ratio is better.

“Buy cheap and sell dear.“

—Benjamin Graham

Types

There are two ways of calculating a P/E ratio. They are:

Trailing P/E Forward P/E
How it’s calculated Price
÷
EPS for past 12 months
Price
÷
EPS that analysts predict for next 12 months
Pro No guessing involved because it’s based on certain numbers Based on expectations, which are what drive stock prices
Con Past EPS is old news; investors and traders care about the future Analysts are often wrong
Drawbacks

The P/E ratio is one of the most widely used metrics investors use for evaluating stocks. But it does have some weaknesses, including:

  • Misleading if profits are inflated due to shady corporate accounting
  • Not always comparable for companies in different industries
  • Can be thrown off by overall market volatility
  • Doesn’t give a good estimate for companies that are growing very quickly
What it is and what it isn't

A P/E ratio is a good back-of-the-napkin estimate, but it doesn’t give a total picture of whether a stock is a good buy.

A company could have a high P/E ratio because its profits are growing incredibly quickly. Judged on the ratio alone, it might look like a bad investment, but the stock could actually have great prospects.

On the other hand, a company could have a low P/E ratio because it’s struggling, and its stock price has fallen. If the company ends up recovering, then investors will do well—but sometimes struggling companies never recover (and investors end up losing everything).

Conclusion

P/E ratios can help investors decide whether a stock is cheap (and a good buy) at its current price or expensive (and a bad buy). The ratio is calculated by dividing a company’s stock price by its profits per share. Although lower ratios are generally better, P/E ratios should be just one factor to consider when evaluating a stock for investment.

Fun facts
  • Over the very long term, the stock market has had an average P/E ratio of about 16, but it’s gone as high as the 120s during times of market volatility.
  • A high P/E ratio isn’t always a bad thing. For much of its history, Amazon has had a P/E ratio of more than 100, but the stock has still delivered incredible returns.
  • If you listen to the news, the stock market seems like it’s important to a lot of people, but in reality only around 55% of people invest in stocks.
Key takeaways
  • P/E ratios can help investors figure out whether a company’s shares are a good investment option.
  • You can calculate the P/E ratio by dividing a company’s share price by either its past earnings or an estimate of its future earnings.
  • P/E ratios don’t mean much on their own, so investors usually use them to compare different stocks.
  • A low P/E ratio is generally better and can mean that a stock is “cheap” relative to its profits. But the metric is just one consideration to weigh when evaluating a stock.
  • There are drawbacks to the P/E ratio that can make it less useful, such as volatile markets and companies cooking their books.

References

https://www.youtube.com/watch?v=4KkTGx2bK_4
https://www.fidelity.com/learning-center/trading-investing/technical-analysis/technical-indicator-guide/pe-ratio
https://www.investor.gov/introduction-investing/investing-basics/glossary/price-earnings-pe-ratio
https://corporatefinanceinstitute.com/resources/knowledge/valuation/price-earnings-ratio/
https://smartasset.com/investing/what-is-a-good-pe-ratio
https://www.investopedia.com/investing/use-pe-ratio-and-peg-to-tell-stocks-future/
https://www.fool.com/investing/2020/10/10/11-hard-to-believe-stock-market-facts/
https://www.nasdaq.com/articles/11-hard-to-believe-stock-market-facts-2020-10-10
https://www.investopedia.com/terms/p/price-earningsratio.asp
https://www.multpl.com/s-p-500-pe-ratio
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