What is a P/E ratio?

By Jordan

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    What is a Price to Earnings Ratio?

    A price to earnings ratio, often referred to as the P/E ratio, is a tool used to measure the relative value of a company’s stock. The ratio is calculated by dividing the current stock price of the company by the company’s reported earnings per share. This ratio is used to provide a comparison between the relative value of different companies or sectors of the stock market.

    How is the price to earnings ratio calculated?

    When calculating a price to earnings ratio, it is important to keep in mind the variables involved. The price to earnings ratio is calculated by dividing the current market price of a stock by its reported earnings per share. It is important to note that the market price should reflect the last known trading price of the stock, and the earnings per share should reflect the company’s most recent reporting period. Additionally, the reported earnings per share should take into account any extraordinary items or non-recurring events.

    In order to accurately compare the relative value of different stocks or sectors, it is important to take into account any factors that may affect the stock’s performance. For example, the P/E ratio should be adjusted to reflect the company’s debt load and its future earnings potential. Additionally, differences in growth rates for different stocks should be taken into account when making comparisons.

    An Example of how to calculate the price to earnings ratio

    Let’s take Apple Inc. (AAPL) as an example. Lets assume AAPL is trading at $121 and that the company’s earnings per share is $4.64. To calculate AAPL’s P/E ratio, we divide the current market price of $121 by the earnings per share of $4.64, giving us a P/E ratio of 26.

    How Can it be Used to Analyze Stocks?

    The P/E ratio can be used to compare the relative value of different stocks. It is particularly useful for comparing stocks of similar market capitalization or in the same industry. It can also be used to identify stocks that are undervalued or overvalued compared to their peers. This ratio can be used to assess the potential for future returns on an investment in a particular stock.

    What are the Strengths and Weaknesses of a P/E Ratio?

    The primary strength of the P/E ratio is that it provides a convenient way to compare the relative value of different stocks in the same industry. It is also a useful tool for identifying stocks that may be under or overvalued. The primary weakness of the P/E ratio is that it does not provide a complete picture of a company’s performance. It does not take into account factors such as future earnings potential or the company’s debt load.

    Historical PE Ratios in the Stock Market

    The historical average price to earnings ratio for US stocks can fluctuate, but at last estimate it’s around 15-20. This number has fluctuated over time and can be used to gauge the relative value of stocks in the current market. For example, when the overall P/E ratio is higher than its historical average, this may indicate that stocks are overvalued and investors should be cautious when making investments or it could mean the company’s earnings have the potential to grow but have yet to materialize in current future earnings reports.

    Differences in Price To Earnings Ratios For Growth Stocks, Cyclical Stocks, and Secular Stocks

    Growth stocks typically have higher price to earnings ratios than cyclical stocks or secular stocks. This is because growth stocks are expected to have higher future earnings and, therefore, have a higher relative value. Cyclical stocks and secular stocks tend to have lower price to earnings ratios, as their earnings are less predictable and their future earnings potential is lower.

    What impact does increasing or decreasing earnings per share have on price to earnings ratios?

    Increasing earnings per share will positively impact a company’s price to earnings ratio. As earnings per share increases, the denominator in the ratio will increase, resulting in a lower P/E ratio. This is an indication that the stock is undervalued and may offer the potential for future returns.

    Conversely, decreasing earnings per share will hurt a company’s price to earnings ratio. As earnings per share decreases, the denominator in the ratio will decrease, resulting in a higher P/E ratio. This can be interpreted as an indication that the stock is overvalued and may not offer potential for future returns.

    Is it always the case that lower price to earnings ratios are good?

    No, it is not always the case that lower price to earnings ratios are good. It is important to remember that the P/E ratio is simply a tool used to compare the relative value of different stocks. It does not provide a complete picture of a company’s performance and should be used in conjunction with other analysis tools. For example, a stock may have a low P/E ratio due to weak fundamentals or a declining earnings outlook. In this case, the low P/E ratio may not be an indication that the stock is undervalued.

    In conclusion, the price to earnings ratio is an important tool for assessing the relative value of a stock and for identifying potential investments. It is important to keep in mind that the P/E ratio does not provide a complete picture of a company’s performance and should be used in conjunction with other analysis tools. Understanding the historical average P/E ratios of the stock market and the differences in P/E ratios between growth stocks, cyclical stocks, and secular stocks can provide valuable insight into the current market.

     

    Recommended Readings:

    1. “Stock Investing for Dummies”

    2. “The Intelligent Investor” 

    3. “The Warren Buffett Way

     

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