The P/E Ratio: What It Is and Why You Need to Know About It

The P/E ratio is a key metric that you need to understand if you want to be successful in investing as it’s one of the most important fundamental analysis tools. It measures how much investors are willing to pay for a company’s earnings. We’ll go over what the P/E ratio is and how to calculate it. Then, we’ll discuss its importance and why you should always use it when making investment decisions. Finally, we’ll wrap up with some tips on how to use the P/E ratio to your advantage.

What is the P/E ratio?

So let’s get started! The P/E ratio is simply the price of a stock divided by the company’s earnings per share (or the EPS). This then tells you how much a person is willing to pay per share for $1 of earnings.

You can find this information for any publicly traded company by looking at their financial statements. A nice easy way to find it online is through Yahoo Finance. Simply search for the stock at the top of the screen and you can see the companies price, its EPS and its PE ratio. As you can see in the below example, not only does Yahoo Finance give you the P/E ratio but you can work it out yourself by dividing the share price ($103.67) by the EPS ($2.09).

There are two types of P/E ratios we look at, the TTM P/E and the Forward P/E. The TTM (trailing 12 month) calculates the P/E ratio by looking at the earnings per share of the company over the last 12 months, whereas the Forward P/E ratio is calculated by looking at the forecasted EPS over the following 12 months.

As you can see from the calculation, earnings make up half the equation. This is important because it investors obviously want to know how profitable a company currently is as well as forecasted profitability in the future.

What does a high P/E ratio mean?

A high P/E ratio indicates that investors are expecting high growth in the company’s earnings and are thus willing to pay more. This is usually seen in young, innovative companies with a lot of upside potential, like a lot of tech companies. For example, Amazon had a P/E ratio of over 2000 at one point because investors were willing to pay a lot for its future earnings growth.

A high P/E ratio could also mean that the stock is overvalued.

What does a low P/E ratio mean?

A low P/E ratio could indicate that investors are not expecting much growth in the company’s earnings and are not willing to pay as much. This is usually seen in more established companies with slower growth rates.

Companies that have a low P/E ratio may also mean a company may be undervalued or that the company is performing really well compared to the past. These are considered to be value stocks. Warren Buffett considers these undervalued stocks to be a bargain buy. It’s buying a company you value at $10 per share at $5.

Unlike stocks with high P/E ratios that are seen in growth stocks, stocks with a lower P/E ratio are commonly seen in more mature industries (such as banks) and may pay dividends.

Why is the P/E ratio important?

Now that we know what the P/E ratio is and how to calculate it, let’s discuss why it’s so important. The P/E ratio is a key metric that you should always use when making investment decisions. It can help you determine whether a stock is overvalued or undervalued. If a company has a high P/E ratio, it may be overvalued and you should avoid investing in it. On the other hand, if a company has a low P/E ratio, it may be undervalued and worth investing in.

How to use the P/E ratio

What’s important to note however, is that a P/E ratio on its own is seldom useful. There are two main ways to use the P/E ratio to your advantage:

The first way is to compare the P/E ratios of different companies in the same industry. This will give you an idea of which companies are overvalued and which ones are undervalued. For example, a high P/E ratio for a lithium stock may reflect a trend within the industry rather than just a specific company.

The second way is to compare the P/E ratio of a company to its historical average. This will help you determine if the stock is currently undervalued or overvalued.

Now that you know all about the P/E ratio, be sure to use it when making your next investment decision!

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