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P/E ratio simplified and how to use it to select stocks

25 Nov 2022 0 COMMENT

Introduction

Many stock investors use fundamental analysis to evaluate if a stock is trading below or above its intrinsic value. One of the tools used to ascertain the value of a company is the price-to-earnings ratio.

As the name suggests, the price-to-earnings or P/E ratio is a metric that determines the relation between market price of a stock vis-a-vis its earnings. It is obtained by dividing the share price of the company by its earnings per share.

P/E ratio = Market share price/ EPS

The P/E ratio is a valuation multiple that helps understand the company’s valuation today compared to its peer companies.

Trailing and Forward P/E Ratio

There are two types of P/E ratios to be aware of—trailing P/E ratio and forward P/E ratio.

The trailing P/E ratio uses past information to arrive at the valuation metric. It can be obtained by dividing the current share price of the company by the total earnings per share (EPS) over the past 12 months. It is a rather accurate representation of the company’s financial position because it is based on the company’s reported earnings.

The forward P/E ratio uses earnings estimates to arrive at the P/E ratio. You can figure it out by dividing the current share price of the company by the expected EPS over the next 12 months. You can use analyst estimates to determine this metric. However, since it is based on estimates, it may not be very accurate. It can still help you understand where the company is headed in the future.

How to Read P/E Ratio for Stock Selection?

As with other metrics, there is little merit to the P/E ratio when looked at in isolation. The P/E ratio of a company needs to be compared with the P/E ratio of its peers. You can also look at the industry-wide P/E ratio and use that as a comparative figure to determine how the company you are analysing is valued.

Typically, it is believed that the lower the P/E ratio of a company, the better it is. Typically, a lower P/E ratio signifies that the company is undervalued and has potential for growth in the future. Similarly, a high P/E ratio means that the company’s shares are overvalued. But that is not true in all cases. A low P/E ratio can also indicate a lower growth prospect for a company and that’s why the market is giving a lower valuation to a stock. Similarly, Stock with a high P/E shouldn’t be considered overvalued all the time. A high P/E ratio could also be due to the high growth prospect of the company. When using the P/E ratio to determine which company stocks to invest in, start by collecting information on the company’s peers. Then compute the P/E ratio for all the companies. If the industry metric is available, use that to determine the relative valuation of each company. Once you know how the company you are analysing is placed compared to other peer companies, you can then decide whether you should invest in it or not.

For instance, if the industry-wide P/E ratio is 15x, while the company you are analysing has a P/E ratio of 10x, it means that it is trading at a discount compared to its peers. But why is the company trading at a lower P/E? It may be because of poor growth or any other negative factor associated with the company. Similarly, a high P/E doesn't always mean overpriced stock. High P/E could be due to the high growth prospects of a company. To make an investment decision, you should also focus on a company's growth. In most cases, companies with poor growth prospects may trade at lower P/E compared to other peer group companies. Companies with a high growth prospect trade at a high P/E ratio compared to other peer group companies. However, it is always advisable to check other crucial financial indicators before taking any investment decision. After analysing the company further and looking into its fundamentals, you can decide to invest in the company. You can find the P/E of a stock here by typing the name of a stock in the search bar.

Conclusion

The price-to-earnings ratio is a simple valuation metric that determines how a company is valued vis-à-vis its earnings. As an investor, you can use this metric to understand how the company is valued compared to other companies in the same sector and make investment decisions based on it.

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