The P/E Ratio Explained and Why it matters
Written by R. A. Stewart
The P/E Ratio is a useful tool for calculating a particular share’s performance. P/E stands for Price to Earnings Performance. This tool is a useful guide because it tells us whether a particular share is overvalued or undervalued.
The P/E Ratio is found by dividing the current share price of the company by the dividend per share.
If the company’s share price was $5 and the dividend per share was $1 then the P/E ratio would be 20.
A company might base its P/E ratio on what it has earned in the past (trailing P/E) or what they expect its earnings to be in the future (forward P/E Ratio).
A higher PE ratio indicates that investors are willing to pay a higher share price today compared to its current earnings.
A lower P/E ratio might be a sign that investors are less willing to pay a higher price for the share compared to its current earnings.
It is important not to get sucked in by a value trap-some companies offer what appear bargains but it is really a sign of financial instability.
A negative P/E ratio means that the company has made a loss. This could be due to expansion-that is when the company sacrifices profits to invest in the company.
However, when a company consistently has a negative P/E ratio it runs the risk of bankruptcy.
Making your investment choices
Which is better, Higher or lower?
Some investors prefer investing in a company with a higher P/E ratio due to its potential for growth while others go for companies with a lower P/E ratio on the grounds that the market has undervalued these companies. A combination of both is often used by investors.
Financial experts say, “You should only compare apples with apples when comparing different companies, P/E ratio.” In other words, only compare it with stocks in similar industries. That being said, if a stock has a higher P/E ratio than its competitors it could indicate that the market believes that it has higher growth prospects than its competitors.
A factor which needs to be considered by investors is that past performance is no guarantee of future performance. There are other factors to consider. A company may have a good year but that may be due to a one off event such as a selling off of assets. The same applies in reverse, a company may have shown a one off loss due to investment into the business.
To Summarise
The P/E ratio is the proportion of a company’s share price in relation to its earnings per share. To work out the earnings per share, divide the stock price by the earnings per share.
About this article
The views expressed in this article are of the writer’s own experience and knowledge and may not be applicable to your personal circumstances, therefore discretion is advised. You may use this article as content for your blog/website or ebook.
Check out my other articles on www.robertastewart.com
