You ever wonder if the stock you’re investing in is a good deal?
There are so many pieces to the puzzle when you’re evaluating a company’s worth.
Lucky for you, investors have a way of evaluating the worth of a stock. And it’s called the P/E ratio.
In this article, we’ll be learning about why the P/E ratio is so important for determining a company’s value.
The P/E Ratio: The metric that tells you if a stock is overpriced
Why should you learn about the P/E ratio?
Let’s use Microsoft for example. Microsoft is a company known for its strong fundamentals.
It has a positive profit margin. Its revenue has increased every year for the past 5 years. It has a great reputation. And the list goes on...
Microsoft’s P/E ratio is high. This means that buying a share of Microsoft is overpriced and is not a good deal.
What does that mean exactly?
Let’s dive a little deeper together.
You ever heard the saying “buy low, sell high”?
Well, when you’re buying a stock with a high P/E ratio, you’re buying high. Which is the opposite of what you want.
It’s kinda like buying a $500 watch for $500. Sure, you’re getting a quality watch. But you’re not getting a good deal on it.
Maybe you’re an experienced investor. Maybe you’re not. Either way, you’re still probably gonna try to look for the best deal you can.
And, that’s where the P/E ratio comes in. It’s important for you to understand the P/E ratio so you can determine whether or not a stock you’re researching is worth your investment.
What exactly is the P/E ratio?
The P/E ratio is a metric used to value a company. The P/E ratio uses the share price and the earnings per share.
Investors also use the ratio to gauge how profitable a company can be in the future.
Don’t let the P/E ratio intimidate you. Even if you have to do a little math, it’s not your enemy. Instead, use it as your friend.
It’s simply a comparison of how much people are willing to pay for it v.s how much it’s really worth.
How to calculate the P/E ratio
For the most part, you can find the P/E ratio of a company on your brokerage app or by doing a simple Google search. That’s right you don’t need to do any calculations to get the P/E ratio.
To fully understand the P/E ratio, it’s necessary to learn how the number is calculated so you understand what exactly is being valued.
The P/E ratio is the current stock price divided by the earnings per share (EPS):
PE Ratio = Share Price Earnings Per Share
Like all things, let’s take this one step at a time.
This one is super easy. You ready?
To find the share price, just look up the stock you want to evaluate. And look at the price.
Bam! That’s your share price.
Earnings Per Share
You can usually find the earnings per share of a company by dividing the net income of the company by the number of shares outstanding:
Earnings Per Share = Net Income /# of shares outstanding
Wait, divide what? By the what?...
Don’t worry, we got this...Let’s break this down together starting with net income.
You can find a company’s net income on the bottom line of its income statement. (If you’d like to know more about the income statement, you can check out our article on fundamental analysis to learn more.)
The net income is also known as the “trailing twelve month” or the TTM. This is because TTM is the company’s net income for the last twelve months.
So, let’s say you go to the XYZ company’s investor relations page. Find their income statement. And see that their net income for the year is $1000.
It’s that simple. Your XYZ company’s net income would be $1000!
Number of shares outstanding
The number of shares outstanding means the number of shares the company allows investors to buy. You can look at this like the supply of shares that a company has available for it’s investors.
Next, you just have to do a simple Google search.
Let’s say you Google “XYZ company shares outstanding” and find that their number of shares outstanding is 100.
This means that XYZ company has issued a total of 100 shares that can be bought.
To find our earnings per share, we would divide our $1000/100
EPS = 10
Let’s make this a quiz! By now, you should be able to calculate a P/E ratio on your own.
So let’s say we’re trying to find the P/E ratio of ABC stock. Their share price is $20. Their net income is $2000. And their shares outstanding is 150.
Give it a second and try not to look at the answer.
PE Ratio = $20 / ($2000 / 150) = 1.5
Your PE ratio for the company ABC is 1.5.
Okay, but what does all this mean??
So, now we know how to calculate the P/E ratio. But what do all these numbers even tell us?
Generally, a high P/E means that a company’s price is overvalued. While a low P/E means that a company’s price is undervalued.
In simpler terms, a high P/E ratio means you’re overpaying while a low P/E means the company is “on sale.”
The P/E ratio can also tell us how a company is performing compared to its competitors or other companies in its industry.
For example, if there is a trend in electric vehicle companies, then it may make sense for us to see high P/E ratios in electric vehicle companies because investors believe that EV companies will increase their earnings in the future.
Tesla for example had a P/E ratio of over 1000 in January of 2021. Which is abnormally high. And in August of 2021, Tesla’s P/E ratio has decreased to around 300. Still an abnormally high P/E ratio but, this means that Tesla’s P/E is beginning to more accurately reflect its earnings rather than the hype of what it can be...
Overall, the role of the P/E ratio is to help you understand if the market is overvaluing or undervaluing a stock. The P/E ratio can be powerful when used in the right context. But alone, it can be misleading.
Things to keep in mind
Remember, no metric is intended to be an end all be all solution. When you’re evaluating stocks, the P/E ratio is just a piece of the puzzle.
The P/E ratio is naturally short-sighted since you’re only using the past year of net income to calculate it.
And just because you find a stock that’s at a “discounted” price, that doesn’t mean it's automatically a good investment.
Like if you were to go to the store and see a jacket for $15. $15 is a pretty good price for a nice jacket. But what if that jacket rips easily? Or what if it shrinks after you wash it? Or what if it's summer and you don’t even really need a jacket? I think you get the picture.
The P/E ratio is a popular metric used by investors. But, as an investor, you always want to be collecting as much information as you can so you can determine whether or not a company is actually valuable.
If you haven’t yet, you can learn more from more of our articles. And as always, continue to educate yourself. If you learned something valuable from this article, you can share it with a friend.
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