The price-earnings (P/E) ratio is a common financial ratio used by investors to valuate a stock. Many investors use the P/E ratio to determine if a stock is overvalued or undervalued. An undervalued stock gives long-term investors a greater opportunity to earn a profit than a stock that is accurately valued or overvalued. Although not the most accurate form of valuation, investors often use the P/E ratio because of the simplicity of the formula. However, with the simplicity of the P/E ratio also comes limitations. Investors must understand the advantages and limitations of the P/E ratio to use it effectively.
The formula for calculating the P/E of a firm is market value per share divided by earnings per share. The market value per share is the current trading price of the stock. For example, if you can currently buy the stock on the market at $100 per share, that is the market value of the stock. Earnings per share represent the profit of a company as it relates to each share of the company's stock. The formula to calculate EPS is net income minus dividends on preferred stock divided by average outstanding shares. If the EPS of a company is $10 and the stock is currently trading at $50 per share, the company’s P/E is 5.
What the P/E Ratio Means
The P/E shows how much investors are willing to pay for every dollar of earnings. If a company’s P/E is 15, investors are willing to pay $15 for every $1 earned by the company. The P/E of a new company that is in its growth stage is typically higher than the P/E of a more stable, mature company. However, one way to understand if the stock is undervalued or overvalued is to compare the current P/E to the company's historical data. Some investors look at historical P/Es of a company up to 10 years back to develop an accurate range. If the current P/E is on the high end of the range, then the stock is likely overvalued. If the current P/E is on the lower end of the range, a better chance exists that the stock is undervalued.
The main advantage of using the P/E ratio is its simplicity. The formula to calculate the ratio is simple and most of the time, investors can find the information needed to calculate the formula on popular financial websites. The use of a company’s P/E is most powerful when compared to similar companies in the industry or the P/E of the entire market. A company with a P/E lower than its industry peers may be a good value. However, you should perform further analysis before investing in the stock.
The limitations of using the P/E for valuation purposes is that companies sometimes use accounting methods to defer expenses in an effort to maximize their net incomes in the current year. For example, a company may use a depreciation method that allows depreciation expense to start off small and then increase as more of the asset is used over time. Investors should use a company’s P/E as a starting point to valuating a stock. A low P/E doesn’t necessarily mean the stock is undervalued and a good investment.
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