What is the PE Ratio?
The formula for the PE ratio is (Price of the stock)/ (earnings per share). So if the stock is trading at $50 and the earnings per share is $3 the PE= $50/$3 or 16.7. Historically the PE is normally between 15-25, however that does is not the benchmark for determining if a stock is undervalued or overvalued. If you want to figure out if the Price to earnings is good or bad you have to compare it to other companies in the same industry group. This is because some industry groups will have higher PE'S in general then other industry groups. This Ratio is supposed to state the investor’s predictions for the stock. The reason the earnings per share is greater than the stock price is because the future growth of the company is also interpreted into that price. It is for that reason that you not only have to look at other similar companies when determining if the PE is high but you also have to look at the growth of a company. If a company is growing very slow and the PE is 60 the stock is probably overpriced. If the earnings are growing and the PE ratio is bad then it might be worth another look. There are a few different problems you may encounter when using the PE ratio. 1. It is open for interpretation. In other words a PE might make a company look undervalued to you but overvalued to someone else. 2. It does not always give you a clear signal. A company with a high PE does not necessarily have to come down just like a company with a low PE does not necessarily have to go up, or it may take many years before it happens. The P/E ratio can be a good indicator of how well priced the stock is compared to what is actually backing it. This is why it has become one of the most widely used financial ratios out there. However stocks do not always behave based on this ratio so it is important to combine it with other indicators before making your decision.
Other Ratios Looking at other ratios can help to give you a good idea on how good of an investment a given stock is. Here are a couple other ratios to look at. PEG ratio - This is an alternative to the P/E Price to Sales Ratio – Looks at the price of the stock and the amount of sales made. Solvency Ratio - Looks at a company and its long term obligations |
