Fundamental analysts use ratios to evaluate the intrinsic value of a stock. One of the most common ratios they use to do this is the P/E ratio. In this article we discuss what the P/E ratio reflects and how to calculate it.
What is the P/E ratio?
This ratio looks to see how expensive a stock is and also how much stock investors are willing to pay for each dollar of earnings.
Price to earnings ratio = current share price /earnings per share
This ratio can show what level the share price is compared to the firm’s current earnings. It is the price investors are paying for the stock with $1 of the company’s profit.
For example, if a stock is trading at $80 and the earnings per share is $5 then the PE is 16. That is, 80/5. So this means the investor is investing $16 for every dollar of earnings. Investors can use the P/E ratio from different companies and compare them to determine which company is cheaper compared to others in the industry.
A high P/E means the stock is expensive compared to what it is earning. This is because investors believe that the company will grow over time and are willing to pay the premium. A low P/E means the stock is cheap and investors believe that the growth will be slow or low in the future.
The problem with P/E ratios:
P/E ratios can be trailing P/E ratios where analysts use past data. However, past performance is not always indicative of future performance. We can also calculate a forward P/E ratio where projected future earnings are used. The downside here is that these are just estimates so they aren’t always accurate.
P/E ratios are used to compare to other companies in the same industry and also to the industry average. This will give the investor an idea of how expensive this company is compared to others in the same industry.
If we look at a company in consumer staples and compare the P/E ratios, we can see which is the more expensive one by comparing P/E, if we have company A with a P/E ratio of 35.81 and industry average is 31.22 and company B which has a P/E ratio of 23.86, we can see company A is more expensive than company B. Company B is even cheaper than the industry average of 31.22.
Lauren Hua is a private client adviser at Fairmont Equities.
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