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How to Value a Stock Using a P/E ratio

August 05, 2019
marker writing words P/E Ratio

Tip of the Week

Examine the P/E ratio of a company before purchasing its stock.

2 min read

It’s important to examine different metrics about how a company performs prior to purchasing any stock. Different indicators can help you understand how well a company is doing, including whether it’s profitable or losing money, or whether its encountering other kinds of problems. One number to consider is something called the P/E ratio.

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What is P/E ratio?

P/E Ratio

The price-earnings ratio is a mathematical formula that measures a company’s stock price compared to its earnings per share.

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Tactics and considerations:

Example:

Here’s what the price to earnings ratio formula looks like, as a mathematical equation:

pe ratio equation

If the stock for Acme Company (not a real company) is trading at $20 a share, and its earnings per share is $5, then its PE ratio is 4*.

Let’s say that Acme  is in the aerospace and defense industry, which has a P/E ratio of 43, according to industry research. The P/E ratio is low for the industry, and the P/E ratio suggests the stock might be good value–in other words, it could increase closer to the industry average over time as its price is relatively low compared to its earnings.

Now let’s say that Acme’s stock is $500 a share, and it’s EPS is still 5. That would give Acme a P/E ratio of 100*, more than twice as high as its industry average. That could suggest the stock may be overvalued.

Other things to keep in mind: Some industries, like technology,  can have very high P/E ratios. That’s because there is often a lot of hype and expectation about how certain stocks will grow over time. (Think about the FAANG stocks, for example, which have some of the most talked about products and services in the market.) More subdued industries, such as financial services, can have lower P/E ratios.

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What is earnings per share (EPS)?

Earnings per Share (EPS)

It’s a mathematical formula that divides profits among each share of common stock outstanding.

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By Stash Team

*Example is a hypothetical illustration of mathematical principles, and is not a prediction or projection of performance of an investment or investment strategy

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