What is a Good P/E Ratio? What is the Significance of P/E in the Investment World?
A Good p/e Ratio Is Between 10 and 20. A good ratio means that the company has enough profit to cover its costs, but not so much profit as to be overvalued by investors. The higher the number of times earnings exceed cost per share, the more expensive it will appear on paper. If you are looking for a stock with a low P/E ratio, look at companies in industries where competition is fierce or new products have just been introduced.
Companies in these situations tend to grow rapidly because they can charge high prices without fear of losing market share. This growth often leads to rapid increases in profits which results in an increase in the price-earnings ratio.
How do I Calculate my own P/E?
You can calculate your own p/e using this formula: x 100 Your p/e / Share Price
Example 1: You bought shares of XYZ Company last year when their net income was $1 million and their sales were $10 billion. Their current net income is $2 million and their current sales are $20 billion. What would be your P/E?
Solution: 2 Million ÷ 20 Billion 0.0125
Your P/E 0.0125 X 100 12.5
Example 2: You buy shares of ABC Company today. They had a net loss of $100 million last year and now have a net gain of $200 million. How many times did their net income go up during the past year?
Solution: 200 Million - 100 Million 100 Million Net Income Increase/Shareholders' Equity
Net Income Increase/ Stock Value X 100 % Change in Stock Value % change in stock value /Old Stock Value.
The above example shows how easy it is to find out what percentage of your investment increased due to a rise in the company's net income. In order to determine whether or not the company is underpriced, compare the company's p/e ratio to other stocks in similar businesses. For instance, if you see a company whose p/e is twice yours, then there may be something wrong with the way the company is priced. However, if the company's p/ e is only half your p/e, then perhaps the company isn't worth buying.
Features of a Good P/E Ratio
There are several features of a good P/E ratio.
1. It should be between 10 and 20. Anything lower than 10 indicates that the company is too cheap relative to its competitors. Any higher than 20 suggests that the company is overvalued. Earnings must exceed costs. Companies that make money selling things like cars, computers, etc., don't need to worry about covering their expenses. But those who sell services such as insurance, banking, real estate, etc., must earn enough to pay all their bills before any extra cash goes into shareholders'
2. It should reflect recent performance. When calculating a company's p/e, use figures from the most recently completed fiscal year. That way, you'll get a better idea of how well the company performed compared to others in the same industry.
3. It shouldn't include extraordinary items. Extraordinary items are anything unusual that happened after the end of the previous fiscal year. These could include special dividends paid to shareholders, acquisitions made by the company, changes in accounting methods used, etc.
4. It should exclude one-time events. One-time events are anything that happens once and never again. Examples might include mergers, bankruptcies, liquidations, reorganizations, etc.
5. It should take inflation into account. Many people forget that inflation affects both the numerator and denominator. The numerator will increase at an even faster rate than the denominator. Therefore, companies can appear more expensive than they really are because earnings aren't adjusted for inflation. To avoid this problem, calculate the p/e using the "real" numbers rather than nominal ones. Real numbers adjust for inflation so that the two sides remain equal.
6. It should also consider dividend payments. Dividends are usually included when determining a company's p/ e. If the company pays no dividends, however, then subtract them from the denominator. This makes sense since investors expect a return on their investments.
7. Finally, it should always be calculated based on current share prices. A company's price doesn't necessarily represent fair market value. Share prices tend to move around quite often. Investors sometimes purchase shares just because they're currently low.
Benefits of a Good P/E Ratio.
1. You know exactly where you stand financially. By knowing the exact amount of profit earned per dollar invested, you have a much clearer picture of how profitable the company actually was.
You can easily tell which companies are truly undervalued. Since many companies look very attractive on paper but turn out to be poor performers, you want to buy companies that seem inexpensive despite having strong financial records.
You can quickly identify potential takeover candidates. Takeovers occur when large corporations acquire smaller firms. Sometimes these deals happen because management wants to expand or diversify operations. Other times, executives simply see an opportunity to boost profits through cost savings. In either case, if a company has a high p/e ratio, it may soon find itself being acquired.
2. Your portfolio looks good. As long as your overall investment strategy includes some stocks with high p/es, you won't run afoul of the law. Stocks with high p/es are considered speculative investments. They don't pay off like bonds do. Instead, they provide higher returns over shorter periods of time. That means there's less risk involved.
If you invest in only safe assets such as government securities, you'll miss out on all those juicy gains. Speculative investments offer better rewards, though. So why not use them?
3. You get a clear idea about what kind of business you own. When you compare the p/e ratios of different businesses, you can determine whether each represents a solid investment. For example, if you own a restaurant chain, you probably wouldn't feel comfortable buying another fast food franchise unless its P/E ratio was significantly lower than yours.
The same goes for other types of businesses. If you own a manufacturing firm, you'd likely prefer to hold a similar type of operation instead of purchasing something completely unrelated.
4. You make smarter decisions. Knowing the true profitability of a particular stock helps you decide whether to sell or keep it. If you think the company isn't going to grow any further, perhaps you shouldn't hang onto it. On the other hand, if you believe the company could continue growing rapidly, you might want to wait until its P/E ratio drops before selling.
A bad p/e ratio indicates that the company is losing money. Such losses indicate problems within the business. It also suggests that investors aren't willing to pay enough for the company's products and services. This makes sense since most people would rather spend their hard-earned cash elsewhere.
5. You avoid paying too much for a bargain. Buying at a discount usually results in greater earnings growth. But this applies only to companies whose P/Es fall below 10. Companies with higher p/e ratios generally earn more revenue from sales. Their revenues increase faster than their costs.
Frequently Asked Questions
1) What does "p" stand for?
P stands for price. The price per share. A common way to calculate the price per share is by dividing the total market capitalization by the number of shares outstanding.
2) How do I know how expensive my stock is?
To figure out how expensive your stock is, divide the current price by the average historical price.
For example: $10 divided by $8 equals 1.25.
This shows that your stock is 25% cheaper today than it was last year.
3) Why should I care about the p/e ratio?
It tells you how profitable a company is. High profit margins mean that a company earns lots of money while spending little. Low profit margins suggest that a company spends more money than it takes in.
Investing involves making smart choices when choosing which stocks to buy and when to sell. One key decision is determining an appropriate p/e ratio. By comparing the actual prices of various companies against their estimated future profits, you can find the best bargains available.