Price-To-Earning-Ratio (P/E Ratio) = Current Price of a Stock ÷ Annual Net Income Per Share.
Price-to-Earning ratio helps an investor to decide the correct current value of a stock and how cheap or expensive the stock is.
Example – If current price of X company is $ 100 per share and Earning per Share (EPS) is $ 10, then P/E $ 10.
If a company earn more per share, the value of it’s share will increase. A stock with high PE ratio can be considered as overvalued and is not worth buying. Good stocks will have a low P/E ratio.
Companies normally price their shares based on its future expected growth. For e.g. if a company is earning $ 1 per share and is expecting a growth of 20% per Annum or $ 2 per share, then it will price its shares accordingly.
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| Price-To-Earnings Ratio (P/E Ratio) |
In simple words, shares are priced at future expected growth of a company. Investors have to pay for future expected earnings of the company. This is where the risks lie. If something goes wrong with the company and it is not able to grow at the expected rate, then prices of its shares will not rise. Also the company will not give expected dividend.
When selecting a stock to buy, it is important to compare present and past P/E ratio of a company. This will give idea if the stock is overvalued or not. Investors must only buy stocks of reasonable P/E ratio. If the fundamentals of a company is very strong with top quality management and high expected growth, then it is wise to invest in the company even if the shares P/E ratio is high.
Resources & References:
- How to Select Best Stocks to Buy
- Fundamental Analysis of a Company
- Using Value, Growth, Income & GARP for Stock Analysis
- Share Market Panic - What to Do? Buy, Sell or Hold?
- Quality of Stocks Vs Quantity of Stocks
- How Many Stocks to Buy - Portfolio Management
- Calculate Price to Earnings Ratio
- S&P 500 PE Ratio
- Definition of Price Earnings Ratio
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