The price-to-earnings ratio, or P/E ratio for short, is no doubt a valuable metric for assessing whether a stock is undervalued or overvalued. But, let’s get to the big question, what’s a good P/E ratio? The subject of what a good P/E ratio is remains somewhat controversial. This is because, contrary to popular belief, a low price to earnings ratio is not the best for gauging a stock’s profit potential. As a matter of fact, it can be an indicator of declining fundamentals.
Moreover, a stock’s price is usually a function of the market’s perception, which sometimes is based on emotions. Despite these shortfalls, experts believe that the lower the price to earnings ratio, the better the investment. If you’re curious to know what a good P/E ratio is, then continue reading.
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What is the P/E Ratio?
Before we discuss what’s a good P/E ratio, let’s define the price to earnings ratio. This will help you understand why we care about a good P/E in the first place.
The price-to-earnings ratio, or P/E ratio, is a stock valuation metric that compares the price of a stock to its earnings or profit. It is also known as the price to earning multiple or price multiple.
The price-to-earnings ratio comes in handy when an investor needs to analyze a stock’s value. This ratio tells the investor whether the company is undervalued or overvalued in the stock market. Also, it tells them how much they’re paying per dollar of earnings.
Stocks with a low P/E ratio mean that the stock price is cheap relative to its earnings. Stocks with a high P/E ratio, indicates that the stock price is expensive relative to its earnings.
How to Calculate the Price to Earnings Ratio
The P/E ratio is calculated as the price per share divided by the earning per share. The result from the calculation is regarded as a multiple. That’s why the P/E ratio is also called earning multiples.
Let’s take a practical example. A hypothetical company, Imaginary Investments, currently has a price per share of $75. The company’s earning per share is $5. The P/E ratio is calculated as follows:
Price to earnings ratio = Price per Share / Earnings per Share = $75 / $5 = 15
This means the market is valuing Imaginary Investment’s shares at 15x the amount of the yearly earnings or profit. If you decide to invest in the company, you’ll be paying 15x the amount it generates in profit for the year. This also implies that at the current share price and profit level, it’ll take Imaginary Investments 15 years to pay back all the shareholders in full.
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Why is the P/E Ratio Important?
Virtually every investor wants to make a return on their investment. For most, the primary objective of investing is profit. Therefore, they don’t simply invest in any company, hoping it performs well. As a matter of fact, the investor thoroughly researches the company to ensure it’s a good buy and will earn them money.
The P/E ratio is, therefore, a valuable metric to assess how profitable a company is and will be in the future. It also gives the investor insight into the price the market is willing to pay for the company’s profits based on its current earnings. The price to earnings ratio can indicate the number of years it will take for the company to pay back the amount paid by the shareholders per share.
This ratio is often used when investors need to compare similar companies within the same industry. A high P/E ratio may mean that investors are willing to pay more for the stock because they expect positive future performance. That explains why companies with a high P/E ratio are often considered growth stocks. Due to the stock’s perceived market value, the share price is usually expensive as a result.
What is a Good and Bad P/E Ratio?
There’s no hard-and-fast rule when it comes to determining a good P/E ratio. But generally speaking, the lower the price to earnings ratio, the better the investment. As a benchmark, a P/E of less than 20 is considered “good” and anything higher than 30 is considered “bad.”
Always keep in mind that sometimes stocks with a low P/E may end up performing poorly. On the other hand, an investment with a high P/E may not live up to it’s expectations. Often, these figures only represent the general opinions to help investors assess a stock’s value — but sometimes those opinions can be wrong.
You should only use the P/E ratio as a benchmark to gauge a stock’s current and future growth. It’s also important to consider other stock valuation metrics rather than relying solely on the P/E ratio to determine a stock’s value. Lastly, remember this ratio is most relevant when comparing companies within the same industry.
What is a Very Low P/E Ratio?
Normally, investors prefer companies with lower P/E ratios since their price is likely to rise in the future. In other words, a low P/E ratio indicates a stock may be undervalued. However, a very low price to earnings ratio can be a red flag. A price-to-earnings ratio of less than 1 is considered very low compared to the company’s expected earnings growth. This doesn’t necessarily mean the company is so undervalued it might fail, but definitely consider other metrics to make an informed decision on buying.
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How Do You Know if a Stock is Overvalued?
The easiest way to know if a stock is overvalued is to look at its P/E ratio. Usually, a stock with an exceptionally high P/E ratio, above 50, is considered overvalued and a quite risky investment. This is especially true if other companies have a much lower P/E ratio in the same industry or market. A very high P/E ratio could mean that stock is incorrectly valued by the market, and its price is not justified by earnings. Rather, their value might be based on emotional perceptions in the market. Normally, these perceptions are not sustainable and the company will usually under perform compared to the perception. This is why such investments are considered high risk.
Investors try to avoid overvalued stocks because it makes no sense to buy stocks at very high prices and eventually make less from them. Although investors who are after short positions look out for these stocks. They leverage the anticipated price declines to make a profit, often through a practice called shorting.
What Does Warren Buffet Say About P/E Ratio?
Warren Buffet is one of the greatest investors of all time and CEO of Berkshire Hathaway. Buffet believes that the P/E ratio is not always the best metric to use when analyzing or valuing a stock. In his opinion, “the ratio of price to earnings has nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.“
Warren was trying to say that P/E on its own is of no real use. It’s too crude to be used as a direct reflection of a company’s value; it does not give you the full picture. To analyze an investment correctly, you need to consider all other vital factors, not just the P/E ratio.
Why Should You Pay Attention to the P/E Ratio?
The P/E ratio is a financial metric that helps you determine the value of a stock relative to its earnings. It tells you what the market is willing to pay for a stock based on its past performance and future growth expectations. This information enables you to make informed investment decisions. You can determine how profitable a stock is and will be in the future before investing. Overall, working with the P/E ratio puts you in a better position to make returns on your investment.
Let’s be honest, no one likes putting their money in the stock market only to see the stock crash. It’s not a fun experience. That’s why investors are being intentional to find an answer to the question, what’s a good P/E ratio? We’ve agreed that a low P/E ratio isn’t a guarantee for a good investment, nor is a high valuation. To make informed investing decisions, consider using the price to earnings ratio as a starting point. Then evaluate other information about the investment to understand the complete picture of the value.
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