How to Evaluate a Stock Using the Price-to-Earnings Ratio?

Learn how to communicate the whole picture, including how to use the price-to-earnings ratio and other tools.

One of the fastest ways to determine if a firm is overvalued or undervalued is to calculate the price-to-earnings (P/E) ratio of the stock. Based on the present price, a company’s stock may be a smart investment if it is undervalued. If it is, you should assess whether the company’s growth potential are sufficient to warrant the stock price.

What is the ratio of price to earnings?

The link between a company’s stock price and its earnings per issued share is gauged by the P/E ratio. By dividing a company’s current stock price by its earnings per share, the P/E ratio is determined (EPS). If you are unsure of the EPS, you can figure it out by first figuring out the company’s earnings (deducting preferred dividends from net income) and then dividing those earnings by the total number of shares outstanding.

P/E ratio illustration
Consider a corporation that has 400 million outstanding shares, a net income of $1 billion, and preferred dividend payments of $200 million. Here is how we would determine its EPS:

400 million shares divided by ($1 billion-$200 million) equals $2 per share.

We can calculate the P/E ratio now that we are aware of the EPS. The P/E ratio would simply be $30 divided by $2, or 15, if the company is now trading for $30 per share.

How to evaluate stocks using the P/E ratio
Examine the type of organisation you are looking into before you begin your study. In some industries or asset classes, a high P/E ratio might be detrimental. You want the P/E ratio to be low while searching for value stocks. Growth investments, however, actually work the other way around. A number of investors will probably want to acquire a company’s shares if its earnings soar.

Although the P/E ratio is helpful, you shouldn’t base all of your stock purchasing decisions on it. For some businesses with low P/E ratios, the ratio will decline even further, and vice versa.

The earnings yield, which represents your share of earnings for each share you own, can be calculated by inverting the P/E ratio.

Restrictions on P/E ratios
The possibility of earnings distortions is the main drawback of the P/E ratio. Earnings per share are calculated using generally accepted accounting principles (GAAP) for net income, so GAAP-compliant earnings aren’t always a reliable predictor of a company’s success. A company’s GAAP net income may change significantly if it adds or subtracts major non-cash items like business unit sales or depreciation.

P/E ratios do not take capital efficiency into account, despite the fact that it is important. A manufacturing firm that needs $50 in capital to generate $1 in earnings shouldn’t be compared to a technological company that needs just $3 in capital to generate $1 in earnings.

To overcome some of these restrictions, you can compute additional ratios. For some industries, ratios such enterprise value/free cash flow, price/sales (P/S), or price/book (P/B) value may be preferable. Before you start your investigation, find out which ratio is typical for the sector.

P/E ratio comparison
The following are the most useful comparisons for the P/E ratio:

Peers

Competitors in a given industry typically have similar firms and revenue streams. Accordingly, P/E ratios in the sector ought to be similar, and positive variations are probably indicative of the strength of the company’s operations or its potential for expansion. A corporation may be an excellent investment if you believe its business is superior yet its P/E ratio is low.

History

One of the best strategies to prevent purchasing stocks with permanently low P/E ratios is to look at the stock’s P/E ratio history. What is the precise catalyst, if a value stock’s P/E ratio is unfavourable and has been for years, that will cause it to trade at higher prices in the future? A growth stock’s price may drop soon if it is currently trading at its highest P/E ratio ever but the growth rate is beginning to slow down.

You can anticipate further expansions by the company over the future years and may be ready to accept a high P/E ratio if the company is still proving out its business strategy and is still in the early stages of its life cycle. Be cautious of numerous contractions and only accept low P/E ratios if a firm has poor or no growth.

Growth

You can compare ratios by figuring out a firm’s P/E ratio as a multiple of the company’s predicted earnings growth rate because a company that is growing quickly may be worth a high P/E ratio. Simply multiply the P/E ratio of a company by either the last few years’ earnings growth rate or a forecast provided by an analyst for the upcoming few years. Companies with low P/E-to-earnings-growth (PEG) ratios, such as those below 1, may be worth slightly higher P/E ratios.