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Buying stocks and investing whether short term or long term require an amount of knowledge that must be built over time. The investing toolbox you develop while researching the market is what will separate you from gamblers and a speculators.
Below is a breakdown of the most common price multiple ratio you should be familiar with when you're looking at stocks. Like anything in the market there are many pitfalls and no one number is full proof, but understanding and knowing when to apply the information will be a new tool to build your portfolio.
Price multiple or price ratios are methods in which investors can compare stocks based on their stock market prices vs other important metrics such as earnings, growth, sales and even book value. Today I will explain the math and common usage behind the most common of these the Price to Earnings ratio.
None of this should be taken as investment advice. This article is only to explain the math and components of the ratio and how it is typically used.
At its base the price to earnings ration (P/E) is the most common and easy to understand valuation ratio today. It has been talked about since even before the classic investing book Securities Analysis was published in 1934. It is also widely reported so any search for a specific stock will present the ratio to you without you having to do any of the simple math.
Why the PE ratio is important?
The PE ratio is important for many reasons. One is because it is talked about and used widely by investors and that alone can affect a stock's price. It's simple and it has a focus on one of the most important functions of a company: Earnings.
How is it calculated?
One the surface the PE ratio is calculated in a very simple manner. You take the price of the stock and divide it by earnings per share (earnings per share is earnings divided by the number of outstanding shares).
The result will inform you how much you're paying for each piece of earnings. Theoretically a high PE ratio means the stock is expensive. But there is no line for what is high and what is low.
The biggest pitfall of the P/E ratio is the bottom of the that fraction. How are you going to look at earnings? Last quarter? Year to date? The last 52 weeks? That all depends on the amount of time you plan to invest in the stock. Keep in mind the reported PE ratio on your favorite finance site doesn't necessarily tell you for what time horizon they are calculating Price to Earnings.
Another major pitfall of a PE ratio is completely math based. If a company has no earning or more likely negative earnings then the PE will be gibberish and not useful in anyway.
How do I use the PE ratio?
If you've answered all the questions above and considered the pitfalls and your time horizon the most common way to gain value from using PE ratios is to compare them to similar companies or other companies in the same industry. If the ratio is high compared to the other companies you've chosen that could mean the stock is too expensive or it could mean the stock is in growth mode and the market likes what it sees. A prospective investor will have to take that information along with other information to make an informed decision.
Using the PE ratio together with other multiples and public information will aid you in deciding which stock is for you.
Are there other ways to look at the PE ratio?
The answer to this question is yes. There are many other versions of the PE ratio that adjust or take a different perspective on the the denominator or earnings portion of the ratio. Explaining the math and intent behind these individually is beyond the scope of this article but as I am able to write new articles I will include links to the below.
The Trailing PE is the price divided by the last four quarters of earnings. A Leading PE or Forward PE uses expected earnings in the denominator. There are also many variations and methods for calculating earnings per share within each of those ratios.
In conclusion the PE ratio is the most common price multiple valuation and can be found with any search of any company's stock. But knowing how it's used and what it's weaknesses are is an important tool for your investing toolbox as you come to your own conclusions on the value of a company. There are adjustments that can be made to base PE ratios to shed more light on a company's value and performance.