Price is what you pay. Value is what you get.
The price-to-earnings ratio, or P/E ratio, helps investors compare the price of a company’s stock to the earnings the company generates. The P/E ratio helps investors determine whether a stock is overvalued or undervalued.
By comparing the P/E ratios companies in the same industry, investors can determine which companies are relatively under or over valued in comparison to their industrial peers.
The P/E ratio is derived by dividing the market price of a stock by the stock’s earnings.
The market price of a stock tells you how much people are willing to pay to own the shares, but the P/E ratio tells you whether the price accurately reflects the company’s earnings potential, or it’s value over time.
If the P/E ratio is much higher than comparable companies, investors may end up paying more for every dollar of earnings.
The typical value investor search for companies with lower than average P/E ratios with the expectation that either the earnings will increase or the valuation will increase, which will cause the stock price to rise.
On occasion, a high P/E ratio can indicate the market is pricing in greater growth that’s expected in the future years.
A negative P/E ratio shows that a company has not reported profits, something that is not uncommon for new, early stage companies or companies undergoing financial perturbations.
Current stock price may be important in choosing a stock, but it shouldn’t be the only factor. A low market stock price does not necessarily correlate to a undervalued or cheap stock.
The P/E ratio is a key tool to help you compare the valuations of individual stocks or entire stock indexes, such as the S&P 500.
References:
- Rajcevic, Eddie, Greenbacks & Green Energy, Luckbox, May 2022, pg. 58.
- https://www.forbes.com/advisor/investing/what-is-pe-price-earnings-ratio/