When you’re making investing decisions and choosing between different stocks, one factor to take into consideration is the P/E Ratio. The P/E ratio is the price/earnings ratio. It’s the price per share of a given company’s stock, divided by the company’s earnings per share. How can it help you as an investor? Let us explain. And if you’re looking for a little more one-on-one guidance, head to SmartAsset’s financial advisor matching tool to get paired with a financial professional who can cater to your specific investing needs.
Why the P/E Ratio Is Important
You probably won’t have to calculate each company’s P/E ratio yourself, but in case you’re curious, the ratio is price-per-share/earnings-per-share. You can see how a low P/E ratio might catch the eye of investors. It could lead a value investor to think that the company’s stock might be undervalued and therefore a bargain worth snapping up.
The P/E ratio is sometimes referred to as the “multiple.” For example, a ratio of 15 means that investors are willing to pay $15 for every dollar of company earnings, for a multiple of 15.
A lower ratio means that investors are paying less per dollar of company earnings, and that it will take less time for the company to earn enough to buy back its shares. So while there’s no hard-and-fast rule that answers the question “what is a good P/E Ratio?”, in general, many value investors consider that lower is better. If you’re looking at two stocks that seem otherwise comparable and are in the same industry, the one with the lower P/E ratio could be a better bet if your goal is to buy undervalued stocks.
Why You Shouldn’t Rely Exclusively on the P/E Ratio
It’s a good idea to take the P/E ratio with a grain of salt. For one thing, a company with a high ratio could have a good reason behind that number. Investors might be willing to pay more because they are particularly bullish about that company’s prospects. A company with high growth prospects could have a high ratio and still be a good buy. So it’s always worth doing other research before buying stocks – not just zeroing in on the P/E ratio.
The ratio isn’t the only number to consider when you’re deciding whether to buy shares. You can also look at the dividend rate if you’re going for dividend investing. And you can look at earnings charts, sales figures and other fundamentals of a company before taking the plunge. Exhaustive research, if you have the time for it, should lead you to more prudent investments.
Comparing stocks for companies in different industries using only the ratio is a risky strategy. Earnings are calculated differently and happen on different timelines in different sectors of the economy. That’s a reason not to compare, say, a manufacturing company and a tech company based solely on P/E ratio.
If you’re buying individual companies’ shares it’s a good idea to understand the P/E ratio, how it works and how investors use it to evaluate stocks. That being said, there’s more to investing than the P/E ratio and a low ratio alone shouldn’t lead you to invest in a given company. Plus, you don’t have to buy individual stocks at all. You can always use a low-fee index fund that takes the guesswork out of buying stocks.
If you’re overwhelmed or struggling to decide how to invest your assets, don’t hesitate to turn to a professional for help. SmartAsset’s financial advisor matching tool can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
Photo credit: ©iStock.com/DragonImages, ©iStock.com/naito8, ©iStock.com/blackred