If you’re starting to immerse yourself in the world of stocks, you’re likely learning a wide array of new terms. One of these may include a P/E ratio, which refers to the price to earning ratio of a stock. If you’re a beginner, you’re probably still getting used to this vernacular and these new practices, which may have you wondering: what is a good P/E ratio? Is it better to have a high or low P/E ratio? How can I calculate the P/E ratio of a stock that I want to purchase?
Let’s break down the key things to know about P/E ratios moving forward in your investment journey.
What Purpose Does a P/E Ratio Serve?
Essentially, the P/E ratio acts as a metric that investors and analysts can use to assess whether a company’s stock price is overvalued or undervalued. It helps investors determine what the market is willing to pay today for a stock from a given company based on that company’s past or future earnings.
Is It Better to Have a High or Low P/E Ratio?
The short answer: the lower the better. Generally, a high P/E ratio means that you’re paying more out-of-pocket to buy a share of the company’s earnings and that the stocks are possibly overvalued. The standard P/E ratio stands at approximately 20-25, meaning a higher P/E ratio is not as beneficial to you in the immediate sense. A good P/E ratio for a stock would generally fall somewhere below the 20 mark, as it indicates healthy organizational earnings and undervalued stocks.
However, it’s worth noting that there are nuances to this concept. Remember that the ratio can be shaped by the industry’s average earnings or the company’s historical earnings. A high P/E ratio simply indicates that investors are expecting the company’s earnings to grow faster in the future, either in comparison to competitors or to its own previous growth. Additionally, if an organization’s earnings are expected to spike, they may also increase their dividends. Higher dividends often lead to a higher stock price and therefore a higher P/E ratio.
How Do I Calculate the P/E Ratio of a Given Stock?
Thinking of investing in a particular stock? Calculating the P/E ratio for that stock is an excellent step to take in completing risk assessment, as it provides insight into how the stock’s valuation compares to its industry group or to a given benchmark.
To calculate the P/E ratio, you simply divide the market value price per share by the company’s earnings per share. Therefore, the equation would look something like this:
Market Value per Share / Earnings Per Share (EPS)
Given that the P/E ratio is one of the most widely used metrics in assessing the valuation of various stocks, it’s a great tool to have in your investment toolkit, especially if you’re just getting started. In gaining a better understanding of whether certain stocks are overvalued or undervalued, you can ultimately make wiser investment decisions with your hard-earned money. This will undoubtedly give you the peace of mind you deserve when buying and trading your stocks.
Video – What is a Trader?
Interesting related article: “What is a Trader?“