Using the Price-to-Earnings Ratio to Assess a StockDec 12, 2021
What Is The Price-to-Earning Ratio and How To Use It To Assess A Stock
P/E Ratio Explained
The P/E Ratio (price earnings ratio) is the price of a stock divided against their earnings. So the pe formula for example is: If a stock has a price of $100 and earnings of $50 their P/E Ratio is 2. The higher the P/E Ratio the more expensive the stock and vice versa.
This is because the price earnings ratio is showing how much investors are willing to pay for every single dollar of earnings. When the ratio is high, this is saying that investors value the stock very highly and are comfortable paying more money for a certain amount of earnings.
For example: if Stock A has a P/E ratio of 4 while Stock B has a P/E of 2, we can see that investors value Stock A's earnings by two times the amount as Stock B!
The reason this happens varies for many reasons but typically, higher ratios occur in higher growth companies (aka companies who are anticipated to make a lot more money in the future). The reason their P/E ratios are higher is because investors believe their earnings will be a lot one day and therefore will pay higher prices now in the hopes that this company become huge down the road.
Outside of what the P/E ratio tells you about a specific company, this is helpful because you can now start to compare the P/E ratios of companies in the same sector.
So if Stock A has a P/E ratio higher than Stock B we know that company is more expensive and therefore we can often assume that investors place more value on the growth prospects of that company.
Where this really helps out is when there is misalignment. Often companies P/E's will skew away from their own historical average or away from their peers. During these periods of deviation we can try to assess why this is happening and if this new valuation is unwarranted.
If it is unwarranted this may be a good buying opportunity!
This is just one of the many ways we use P/E! If you want to learn more on P/E and other important metrics, check it out: here
So if you were wondering, "what is p e ratio, what is price to earnings ratio or what is the p/e ratio meaning?", we hope this was helpful. This is pe ratio explained the Moby way.