PE Ratio

P/E Ratio Ratio Explained

5 min read

The P/E ratio, also known as the price earnings ratio, looks at a couple different components to make up a stock’s value. It measures the price of the stock relative to the annual net income that was earned by the company per share. Fundamentals are really important to look at when you’re going to invest. In fact, its one of the biggest parts of investing, next to “expectations” and “sentiment”.

The price earnings ratio or P/E ratio finds the value of a company by measuring it’s current share price to it’s earnings per share. In other words, the price earnings ratio tells you the dollar amount you can invest in company in order to receive $1 of that company’s earnings.

Investing is more of a long term plan. As a result, it’s important to diversify your investment portfolio. You want risky and safe investments. Typically your age also dictates how you invest because the older you get the more you want to protect yourself.

The goal of investors should be to get the best possible deal when buying stock. Sometimes, because investing is long term, stock market basics like patterns as well as support and resistance aren’t taken into consideration.

The better the deal you get, the more profit potential you have. So you can look at where support and resistance are as well as the patterns. Those can be used to get a better entry for you long term.

The great thing about investing is the other factors that can help determine a good investment like the P/E ratio. As a result, looking at the stock’s price plus the price earnings ratio also gives great insight about the right time to buy.

Just because a stock is a good long term investment, doesn’t mean it’s the right time to buy. That’s part of the problem with new investors. They know stock XYZ is a good long term buy. However, it’s getting ready to go in a bearish direction.

If you wait for a good buy signal, then you have more profit potential in the long run. You still may end up profiting with a bad entry but the better the entry, the better the profit potential.

How Do You Calculate P/E Price Earnings Ratio?

  • How do you calculate the P/E ratio? In order to calculate the price earnings ratio, you have to know the earnings per share. The earnings per share are made up of the financials from the last 4 quarters. As a result, the P/E ratio is dividing the current stock price by the earnings per share. How do you find out the earnings per share? If it isn’t readily available you can figure it out yourself.

What you have to do is subtract the companies preferred dividends from its net income. Then divide that result by the number of shares outstanding.

For example, let’s say the stock you want to invest in has a net income of $3 billion and pays $300 million in preferred dividends. It also has 400 million shares outstanding. As a result, the earnings per share would be $6.75. It’s easier to calculate than it looks.

Once you know the earnings per share, you can figure out the P/E ratio. Lets say the stock is currently trading at $50 a share. To find the price earnings ratio, you’d divide the $50 by the $6.75. Which would be 7.40.

Investments

Now that we know how to calculate a P/E ratio, do high or low ratios affect investments? As we stated earlier, finding a good entry point on an investment gives you better profit potential.

As a result, a stock’s current price tells you what investors are currently valuing the stock at. Whereas the price earnings ratio tells you how much investors would be willing to pay per very $1 the stock earns.

In essence, the P/E ratio gives you a better insight into the potential growth of a company. So what does a high P/E ratio mean? The higher the price earnings ratio, the more investors expect higher earnings.

Does that mean that the higher the P/E ratio the more of a sure thing the investment would be? The answer is no. In fact, sometimes a high price earnings ratio can signal that a stock is currently overvalued.

Overvalued stocks will give that value back. You can always look at the intrinsic value of a stock to see if it is in fact overvalued. A low P/E ratio can indicate that the stock is currently undervalued.

Investors can snap those undervalued stocks up to capitalize on the that move. In essence, you’re getting a stock at a discount so when it climbs back up, you’re entry was better and your profit potential rises.

However, a low P/E ratio can also be a signal of potential lack of growth. Hence the importance of fundamental analysis and intrinsic value for investors. If there’s no future growth, that investment won’t pay out for you.

Bottom Line

The P/E ratio gives investors a sense of a company’s potential growth. If you want a good payout over a long period of time, you want to get into a company that has the potential for long term growth. 

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