Using Price/Earnings Ratio to Evaluate Stock

The price/earnings ratio (P/E) is the tool most commonly used to help investors value stocks. It is a measure used by investors to tell whether a stock is underpriced or overpriced. It relates a firm’s current market price to its net earnings for the past year. The earnings of a firm are considered a good indicator of a firm’s worth. A stock’s current market price indicates the value that investors assign to it based on their beliefs about the company’s current and future earnings. Therefore, a stock’s current market price is usually greater than its current earnings per share. If a stock is trading with a P/E ratio greater than 20/1, it often means investors expect strong future growth in earnings of that corporation.

Things To Know

• Use price/earnings ratios to tell a company’s worth.
• P/E ratios tell you whether a stock is undervalued or overvalued.

How to calculate it

Calculating a P/E ratio is simple to do. You simply take a firm’s current market price and divide it by the net earnings per share for the last 12 months.

Price/earnings ratios are useful when comparing companies in the same industry. The company with the lowest P/E ratio may be undervalued and a better stock pick. A company’s P/E ratio compared to an industry average may be useful to deciding whether to buy or sell a stock.

The price/earnings ratio is one of the easiest tools you can use to measure the value of a stock. You can use it to measure whether a stock is undervalued or overvalued, which will help you decide whether to buy or sell it. P/E ratios can help you sort the "winners" from the "losers," and are so important that you can find them in the business section of your local paper.

P/E ratios for most stocks are listed in the business section of your local paper.

How they are useful

P/E ratios are useful when comparing companies in the same industry. The company with the lower P/E ratio may be undervalued and a better stock pick. A company’s P/E ratio compared to an industry average may be useful in deciding whether to buy or sell a stock.

One caveat

Although the formula is very simple to calculate, there are many factors that influence either a firm’s earnings or its stock price. It is very important to do a thorough analysis of these two components before relying on the P/E ratio. Once you have an accurate P/E ratio for a firm, it is always a good idea to compare it to those of competitors and the price/earnings ratio of the overall market.

Although P/E ratios are quoted in financial publications, most analysts adjust them to account for factors that can distort their meaning. Some external factors may include inflation, interest rates, temporary recessions, and investor exuberance. Internal factors may include expectations of future growth, debt-to-equity ratio, quality of management, and accounting practices.