When evaluating a portfolio or determining what companies to invest in, investors are usually only interested in one thing — getting a good return on investment. They want to determine which companies are most likely to have a positive effect on their portfolios and which are more likely to tank. But with so many different companies with vastly different valuations to choose from, where does an investor even begin? While there are multiple factors to consider when selecting what stocks to include in your portfolio, determining a company’s P/E ratio can be a valuable place to start.
What Is a P/E Ratio?
P/E ratio stands for Price Earnings ratio. This is a formula investors can use to help standardize stocks, since they often have different prices and earning levels across companies. On its own, a company’s P/E ratio won’t tell you much. Instead, it is a tool used to compare stocks across similar company types or to compare a company’s current stocks against its own historical records. Once a P/E ratio has been determined, it can be used by investors to help determine if a stock price is overvalued or undervalued.
How Does a P/E Ratio Work?
The P/E ratio is the share price divided by the earnings per share.1 To find the earnings per share, subtract a company’s preferred dividends from its net income, and divide that total by the number of shares. For example, if a tech company’s net income was $3 million dollars, the preferred dividends came to $400,000 and the total number of shares was 500,000, this is how you would determine the earnings per share:
(3,000,000 - 400,000)/500,000 = (about) $5 per share
To then find the company’s P/E ratio, you would divide the company’s current share price of $30 a share by the earnings per share we just calculated:
30/5 = 6
This means that for every dollar the company earned, investors paid $6.
On its own, the number six won’t tell you very much. But when you compare it to a similar tech company in the industry’s P/E ratio of nine, you can get a clearer understanding of what direction others believe this company’s future earnings will go. Using this information, investors can then make a more knowledgeable determination of whether or not they are paying a fair price for their stocks.
Analyzing P/E Ratios
It’s easy to compare the number six to nine - one is clearly higher than the other. But how does that translate to your stock options and current holdings?
Evaluating High P/E Ratios
If a company has a comparatively high P/E ratio, that means investors likely consider it to be a growth stock. Expectations are high that the stocks will perform well in the future, meaning greater earnings for investors who are, therefore, willing to pay higher prices for them now.
Based on this information, choosing a stock option with a higher P/E ratio may sound like a no-brainer. But it’s important to take other investment considerations into account before buying. For example, these growth stocks are usually considered more volatile, which can often times make them a more risky investment option.
Evaluating Low P/E Ratios
Alternatively, if a company has a low P/E ratio, they are considered to have value stocks. These undervalued stocks can often be appealing to investors, as the investor can buy in at a bargain. This is, of course, with the assumption that the stock will eventually rise in value as investors buy in and the company’s evaluations changes.
While it shouldn’t be the sole indicator of whether or not you purchase stock from a company, determining the company’s P/E ratio is a great place to start. It allows you to level the playing field and compare apples to apples the value of each company in a certain industry. Based on the results, you can go about making a more educated decision about your investment holdings.
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