There are as many approaches to analyzing an investment as there are flavors of cake. Some may prefer a vanilla approach that keeps things simple and sweet, while others like to dive into the dark depths of a chocolate death. Regardless of your taste preferences, it’s wise to have a method to your madness when picking stocks.
“Stock prices can move a lot, so having multiple ways to determine a stock’s value is important information when deciding whether to buy or sell a stock,” says Ayako Yoshiokaa senior portfolio manager at Wealth Enhancement Group.
One such method is using the price-to-earnings ratio, or P/E, which can help you gauge whether you’re getting a good deal on a stock’s price.
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What is a P/E ratio?
“P/E tells investors based on current earnings how expensive or cheap a company’s current price is,” says Terry Sylvester Charronsenior director of the Family Wealth Investment Advisor Group, BNY Mellon Wealth Management.
It is calculated by dividing the current share price by the company’s earnings per share (EPS). EPS is earnings for the previous 12 months divided by the number of shares of stock outstanding.
The good news is that you will rarely need to calculate the P/E yourself. Most financial websites include this data on their stock analysis pages. If you want to verify the website’s calculations or just prefer to crunch your numbers, you can usually find EPS on a company’s income statement under net income.
What does the P/E ratio tell you about an investment?
“The P/E ratio shows how much an investor is willing to pay for $1 of the underlying company’s earnings,” says Andrew Crowella financial advisor and vice president of Wealth Management at DA Davidson.
For example, of Apple (AAPL)’s P/E at the time of this writing is 29. That means investors are paying $29 for $1 of the company’s earnings.
“The P/E ratio gives us insight into how the market perceives the earning potential of an investment,” says Charron. “For example, companies with faster earnings growth potential and more stable earnings power will often have a higher P/E ratio than companies with slower growth and/or lower quality earnings. “
P/E ratios can vary by sector, with companies in one sector tending to have higher multiples than those in another sector, Crowell says. They also tend to take a long time to rise bull markets and long contracts bear marketstherefore it is important to keep the context in mind when analyzing the P/E.
How can you use the P/E ratio when investing?
You can use the P/E ratio to compare stocks to their peers or the market in general.
“For example, all other metrics being equal, one industrial stock with a P/E of 17 is more expensive than an industrial stock with a P/E of 13,” says Crowell. “If the two companies have similar growth rates, earnings, debt levels, etc., that implies that Higher P/E. Stock /E is more expensive than the lowest.”
As with most buying decisions, you never want to overpay for an investment, so choosing companies with low P/Es can be a smart investment strategy.
“Buying stocks at the right price is critical, and having the discipline to not overpay can help an investor make smart investment decisions,” says Crowell.
You can also look back in history and see where the stock’s average P/E ratio has been and whether the current P/E is at a premium or discount, says Yoshioka.
That said, it’s dangerous to oversimplify the power of the P/E ratio. Low P/E stocks aren’t necessarily safer than high P/E stocks, Crowell says. “P/E is simply a measure of valuation.”
A company’s reported earnings can change based on accounting changes, adjustments made by the company and other fluctuations, so having an additional form of valuation is also helpful, Yoshioka says.
It recommends price to sales (P/S) or price to sales (P/FCF) cash flow. Each of these metrics has a similar approach to P/E. Simply replace the EPS calculation at the bottom of the equation with the company’s sales or free cash flow.