The P/E ratio, or price-to-earnings ratio, is a quick way to see if a stock is undervalued or overvalued. As it sounds, the metric is the stock price of a company divided by its earnings per share. What makes a good P/E ratio depends on the industry, though, generally speaking, the lower the number, the better. That said, you shouldn’t compare P/E ratios of different kinds of companies, like a tech company and a consumer staple company. In other words, the metric is only useful when comparing apples to apples.
Do you have questions about a particular investment? Speak with a local financial advisor today.
Why the P/E Ratio Is Important
You don’t have to calculate each company’s P/E ratio yourself. After all, you can just Google it. But in case you’re curious, the ratio is the share price divided by earnings per share.
The resulting number tells you how much you are paying per dollar that the company earns. For example, a ratio of 15 means that investors are willing to pay $15 for every dollar of company earnings. This is why the P/E ratio is sometimes referred to as the “earnings multiple” or just “multiple.”
You generally use the P/E ratio by comparing it to other P/E ratios of companies in the same industry or to past P/E ratios of the same company. If you are comparing same-sector companies, the one with the lower P/E may be undervalued. Or if you’re looking at past data for one company, a higher number could mean it’s no longer a bargain.
Ultimately, there’s no hard-and-fast rule for what is a good P/E ratio. But in general, many value investors consider that lower is better.
Why You Shouldn’t Rely Exclusively on the P/E Ratio
The P/E ratio seems like a straightforward calculation, but what you use for earnings can be tricky. For one thing, earnings are reported by each company, and accounting practices are not the same across the board. There’s also the possibility that a company is inflating earnings by devaluing or hiding costs.
That’s partly why it’s a good idea to take the P/E ratio with a grain of salt. Another reason: a company with a high ratio could have high growth prospects. Its ratio is high because it just spent a lot of money to grow its business. So it could still be a good buy.
In other words, you shouldn’t just zero in on the P/E ratio when you’re deciding whether to buy shares. There are many other metrics to consider, including earnings charts, sales figures and other fundamentals of a company. You can also look at the dividend rate if you’re going for dividend investing. Exhaustive research should lead you to more prudent investments. If you don’t have the time, consider hiring a financial advisor.
It’s a good idea for investors to understand the P/E ratio and how to use it to evaluate share prices. But it’s only one of many available metrics. It shouldn’t be used alone, and it shouldn’t be used to compare companies that are in different businesses. That said, it is a handy way of seeing if a stock is a bargain or not.
Tips to Become a Better Investor
- Financial advisors often have years of experience managing investments, making them great partners for anyone looking to improve their portfolio. To find local advisors that meet your specific needs, use SmartAsset’s free matching tool. If you’re ready to build a better portfolio, get started now.
- Exchange-traded funds, or ETFs, can be a great way to quickly flesh out your existing portfolio. Like mutual funds, ETFs are baskets of stocks that carry less overall risk than an individual company’s stock does. But unlike mutual funds, ETFs are easily traded, so you can buy or sell them very quickly.
Photo credit: ©iStock.com/DragonImages, ©iStock.com/naito8, ©iStock.com/blackred