There are a LOT of different ways to value stocks. You can look at a specific stock to buy or sell through a whole bunch of different lenses. And depending on what you are doing and what your goals are, you will need to use a different combination of those lenses. However, there are a few different calculations that are important to understand when valuing which stocks to buy or sell. One of them is the Price to Earnings Ratio (P/E ratio). Here’s how it works.
What is a P/E Ratio?
A P/E ratio is short for price to earnings ratio. It compares a company’s stock price to the earnings that each share of stock makes.
It is one of the ratios that are really important to know and understand when you start dabbling in stock buying and/or selling.
One of the nice things about a P/E ratio is that it can be easily found on a various number of investing websites. Here is a good example of how easy it is to find it on Yahoo! Finance:
P/E Ratio Calculation
The P/E ratio is a relatively easy calculation. It is simply the stock price divided by the annual earnings of a company.
For example, if a company has a stock price of $50 and the annual earnings of that company are $5, the Price/Earnings ratio would be 10.
Stock Price = $50
Earnings Per Share = $5
$50 / $5 = 10
What Does a P/E Ratio Tell Us?
This is the big question. It’s nice that we have a number for a price/earnings ratio. But if we don’t know what that means, then it’s pretty useless.
Here is what a price/earnings ratio means.
A P/E ratio tells us how much we pay for the stock compared to how much profit the company actually brings in per year.
In the last example, the price/earnings ratio was 10. That means that we paid 10x the annual profit of the company to buy the share.
This calculation also implies that it would take 10 years for the company to repay you from their profits for your share (were the stock price and profit/earnings to remain the same over that time).
Also, a P/E ratio can be used as an indicator to a stock being overvalued or undervalued. (It is important to note that this should not be the ONLY indicator though.)
When to Use a P/E Ratio
A price/earnings ratio by itself is probably not a great metric for deciding to buy or sell a stock. However, it is really handy when comparing different companies in the same industry.
Here is a good example of a couple companies to compare:
Happy’s Golf Clubs:
Stock Price: $50
Earnings: $10
Price/earnings ratio: 10
Shooter’s Golf Clubs:
Stock Price: $80
Earnings: $10
Price/earnings ratio: 8
What does this tell us? This tells us that Shooter’s Golf Clubs are a better value than Happy’s Golf Clubs. This is because the P/E ratio for Shooter’s Golf Clubs is lower.
If each company were to maintain the same stock price and earnings, it would take Happy’s Golf Clubs 10 years to repay your money for buying one share and Shooter’s Golf Clubs 8 years to repay your money for buying one share.
Even though Shooter’s Golf Clubs stock is more expensive, it is actually a better deal than Happy’s Golf Clubs.
It is important to note that when comparing two (or more) companies, that they need to be in the same industry. Different industries have different “good” and “bad” average P/E ratios.
For example, a company like Tesla which is growing rapidly and expanding quickly shouldn’t be compared to a company like McDonalds which is much older and is in the maturity stage of the industry.
However, Tesla and Rivian would be a good comparison just like McDonalds and Subway would be a good comparison.
Final Thoughts
Like I said before, when looking for an investment, you need to look at it through several different lenses. This is simply one of those lenses. But it is one of the most basic and important ones to start with.
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Until next time!
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