When you buy stock, you’re essentially buying a tiny piece of the company it represents. Understanding how profitable the company is in relation to its stock price can be an important consideration for investors.
The definition of the price-to-earnings ratio, usually called a P/E ratio, is the ratio between how much a stock costs and how much in profits that company is making. Investors can use P/E ratios to find affordable stocks when the market is expensive.
You find a P/E ratio by dividing a stock’s share price by the earnings per share, or EPS, which is simply the total net profits from the last year divided by the total number of outstanding shares.
So, if a company has a share price of $20 and an EPS of $0.50, that would give it a P/E ratio of 40. Looking at it simply, the number in a P/E ratio tells you how much you have to pay to get one dollar of underlying company profits. If a company has a share price of $20 and an EPS of $0.50, you need to spend $40 to get the equivalent of one dollar of earnings (two shares).
Share prices change on a daily basis and new earnings figures are released every three months. As a result, a company’s P/E ratio will change constantly.
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What Is a Good P/E Ratio?
A lower P/E ratio is typically better because it means you’re getting more bang for your buck, but there are many different factors to a good P/E ratio and a bad one.
Different industries have different standards for what constitutes a good P/E ratio, and the size or age of a company can also play a major role in how the market will view a company’s ratio of price to earnings. If you’re trying to decide between buying stock in a massive, established investment bank and a plucky young biotech firm, just comparing their P/E ratios won’t be very useful.
Comparing a company to other similarly sized companies in the same type of business is the best way to judge what a “good” price-to-earnings ratio is. If a stock has a lower P/E ratio than its peers, that’s generally a good sign.
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How to Use P/E Ratios When Picking Stocks
Price-to-earnings ratios are one of the most valuable metrics when picking stocks, and investors can follow the practice of “value investing.” This means that you should invest in stocks with low P/E ratios, where you’re getting good value for your investment dollar. Warren Buffett is one of the most notable value investors.
P/E ratios can also paint an incomplete picture, however. Some companies might have high P/E ratios because they’re reinvesting all of their profits internally to become bigger, better companies. They might look expensive based solely on their earnings ratios, but if their lack of profits means they’re growing rapidly, they’re probably still going to be a strong investment in the long run.
A company with a low P/E ratio could be an old company with an outdated business model that’s on the decline. Investors commonly refer to this as a “value trap.” The company may still be profitable, but its prospects for the future are bleak, meaning it wouldn’t be a smart stock to buy.
A company that has taken on lots of debt to fund expansion will likely have a better P/E ratio than its peers as the money it is borrowing doesn’t reduce earnings. This company might be a much weaker stock overall because of its larger debt load.
Do Your Homework
You should always consider a stock’s P/E ratio before investing, but remember the number is just one piece of a much bigger puzzle. Any purchase of stock should involve carefully researching the company. Be sure that, in addition to knowing its P/E ratio, you also understand what the number means in the context of the underlying business.