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Investing in the stock market can get pretty complicated if you’re just starting out. There’s various topics to learn as you go and try to get some experience. One of them is the price to earnings ratio or P/E ratio. The concept of a price to earnings ratio can be a little confusing but after you see the simple formula to calculate it, it’s not too bad. So let’s get started!
The price to earnings ratio, or the P/E ratio, in stock market investing terms is the ratio between a stock’s share price relative to its earnings per share, or EPS. In other words: P/E = Stock Price/Earnings Per Share (EPS) The earnings per share or EPS, is found through the company’s last four quarter earnings. It’s simply the earnings/number of outstanding shares.
Types of P/E:
There are two common types of price to earnings ratios. The trailing P/E ratio and the projected or forward P/E ratio. The trailing P/E ratio is the current actual P/E ratio. It takes into account the stock price and the EPS of the last four quarters of a particular company.
The projected or forward P/E ratio however, is more of a predicted P/E ratio. Instead of using the EPS of the last four quarters, the earnings for the next four quarters are rather estimated by analysts. This estimated EPS is then taken into account when determining the forward P/E ratio.
How To Use The P/E Ratio When Investing:
The P/E ratio is just one metric, however, to truly understand the value of a certain stock many more aspects must be taken into consideration before deciding if the stock is worth a buy or not. But nonetheless, the P/E ratio can serve as a quick glimpse at a company’s financials without looking too much into it.
A high P/E ratio typically means that investors are expecting higher returns from that company. If we think about the formula again, a high P/E means that the stock price is much higher than it’s earnings. This could be because there may be many investors willing to put their money in that stock. However, it’s not always the case there could be other reasons. One of them could be that the stock may be overvalued or their earnings aren’t very high.
A low P/E ratio generally means that the company has improved from its past performances or that it’s currently undervalued. Again, this may not always be the case but it’s a common way of looking at it. Now you can use the P/E ratio to help you invest better in the stock market. But, there are certain things you should be aware of when looking at P/E ratios.
The P/E ratios can differ greatly between two different stocks. That doesn’t necessarily mean that either one of the them is good or bad. You can’t compare two very diverse stocks that are in completely different sectors. For example, comparing a tech stock to a gasoline company. And even if both companies are in the same department, it could still be a little tricky to compare the two.
There are many different factors that could go into each company’s earnings, stock price and etc. This is one the drawbacks to only using the P/E ratio when investing. There could also be more such as how biased and accurate the company’s earnings are and the analysts expectations and such. So, it’s a good idea to dig deeper and research more into the company before deciding if it’s a good buy or not.
Analyzing the company’s P/E ratio and trying the understand it can be a good start when looking at stocks. Check out some of these related posts to learn more about investing in the stock market!
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