It’s important to examine different metrics about how a company performs prior to purchasing any stock. Different indicators can help you understand how well a company is doing, including whether it’s profitable or losing money, or whether its encountering other kinds of problems. One number to consider is something called the P/E ratio.

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What is P/E ratio?

P/E Ratio

The price-earnings ratio is a mathematical formula that measures a company’s stock price compared to its earnings per share.

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Tactics and considerations:

  • Look at the P/E ratios of other companies in the same industry or sector as the company whose stock you’re considering.
  • If the P/E ratio is higher than the average, that could mean the company is overvalued. If it’s lower, that could mean it’s undervalued.
  • Generally speaking,  a high P/E ratio reflects an expectation of higher growth in the future. But a high P/E could also mean that a stock’s price is high relative to its earnings, and possibly overvalued.
  • By contrast, a low P/E ratio may suggest an investment opportunity as the stock price is low relative to its earnings. But this could also suggest that the company has a problem, such as a bankruptcy or threat of a lawsuit.
  • Similarly, it’s important to pay attention when the P/E ratio of an entire industry or sector climbs above, or falls below, its historic average.
  • Remember, the P/E ratio is just one of many metrics to consider when purchasing a stock. Other things to consider could include profit, revenue, and debt.

Example:

Here’s what the price to earnings ratio formula looks like, as a mathematical equation:

pe ratio equation

If the stock for Acme Company (not a real company) is trading at $20 a share, and its earnings per share is $5, then its PE ratio is 4*.

Let’s say that Acme  is in the aerospace and defense industry, which has a P/E ratio of 43, according to industry research. The P/E ratio is low for the industry, and the P/E ratio suggests the stock might be good value–in other words, it could increase closer to the industry average over time as its price is relatively low compared to its earnings.

Now let’s say that Acme’s stock is $500 a share, and it’s EPS is still 5. That would give Acme a P/E ratio of 100*, more than twice as high as its industry average. That could suggest the stock may be overvalued.

Other things to keep in mind: Some industries, like technology,  can have very high P/E ratios. That’s because there is often a lot of hype and expectation about how certain stocks will grow over time. (Think about the FAANG stocks, for example, which have some of the most talked about products and services in the market.) More subdued industries, such as financial services, can have lower P/E ratios.

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What is earnings per share (EPS)?

Earnings per Share (EPS)

It’s a mathematical formula that divides profits among each share of common stock outstanding.

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