Whether you are a retail or institutional investor, knowing how to value a stock is important because it can help you better understand a stock’s potential (or lack thereof). One key metric to consider is something called Price-to-Earnings ratio, otherwise known as P/E ratio.
What Is It?
A P/E ratio is essentially a “mark” that measures a company’s stock price compared to its earnings per share — letting you know how much investors will pay for each dollar of a company’s profits. Knowing the P/E ratio is important because it provides a “yardstick” (if you will) to see if a stock is either overvalued or undervalued. Overvalued means that the company’s stock is trading higher than the market value while undervalued means it trades lower than its market value. In most cases, overvalued and undervalued stocks present good “sell” and “buy” opportunities.
There may be a few reasons why a company’s stock is either overvalued or undervalued. Generally speaking, a stock is one or the other if there’s a difference between financial analysts’ growth projections and the company’s actual fundamentals. If growth projections outweigh the fundamentals, then it usually means the stock is undervalued. Likewise, if the fundamentals outweigh growth projections, then the stock is overvalued.
To calculate the P/E ratio, simply divide a company’s current stock price by its Earnings Per Share (EPS). EPS can be calculated by dividing the total subtraction of a company’s preferred dividends and net income to the number of outstanding shares. For example, let’s say that your (imaginary) company’s stock price trades at $20 per share with an EPS of $2. Your P/E ratio will then come out to be 10. This is basically saying that you will pay $20 for every $2 of the company’s earnings. If your company is in finance, the average P/E ratio for financial services, including banks, capital markets, and insurance, comes out to be 14.26. Compare this with your company’s P/E ratio, which is 10, it means that your stock is most likely undervalued. As P/E ratios differ from industry to industry, it’s crucial for investors to compare companies from the same industry.
Stock Price & P/E Ratio
While not the only metric to valuing a stock, knowing the P/E ratio is definitely one of the easier ways to assess a company’s potential. A high P/E ratio means that investors expect higher earnings. That’s because the demand is driven by investors’ rising confidence in the particular stock. However, a high P/E ratio, or overvalued stock, doesn’t necessarily mean it’ll actually bring more earnings. In fact, it can run the risk of losing money if it fails to meet investors’ expectations. On the flip side, a low P/E ratio reveals undervalued stocks. This can suggest an investment opportunity as the stock price is low compared to its earnings — perhaps a genuine growth potential in the future. However, a low P/E ratio can also suggest that a company has issues such as a lawsuit, bankruptcy, or scandal.
Please keep in mind that P/E ratio is just one of the many financial ratios you can use to calculate and measure a stock value. For example, there’s Price-to-Book ratio, or P/B ratio, which compares a company’s net assets to the price of all outstanding shares. Or there’s Debt-to-Equity ratio, or D/E ratio, which shows the proportion of equity to debt a company uses to finance its assets. Furthermore, P/E ratio has certain limitations. If we look at the formula, coming up with the first part — stock price — is pretty straightforward. However, finding the accurate earnings number isn’t always so clear cut. In fact, earnings can be manipulated by companies to meet earnings expectations. Therefore, investors definitely need to be more wary of this fact when using the P/E ratio to assess stock values.