When evaluating a company as a potential investment, there are so many factors to look at. One of them is the P/E ratio. This calculates the relationship between a company’s share price and earnings. With this number, you can decide whether a company is over- or under-valued.
“The P/E ratio is a helpful statistic when it comes to determining a company’s financial health,” explains Richard Cayne of Meyer International. “It is one of many that investors should be familiar with.”
What is a P/E ratio?
A P/E ratio is simple. It’s a company’s price per share (P) divided by its earnings per share (E). The resulting ratio, or whole number, is a general indication of what the market is willing to pay for a company’s earning. For example, if a company has a share price of $10 and reports an earnings per share of $5, then its P/E ratio is 10/5, or 2. So, you could assume that investors would pay $2 for every $1 the company earns.
And of course, there are variations. Some analysts use different earning numbers to calculate these ratios. Most often is whether they use earning from the past 12 months (trailing P/E) or estimated earnings for the next 12 months (forward P/E).
What does a high or low P/E ratio mean?
Depending on your outlook, a high P/E ratio means a company is overvalued. After all, investors are paying so much more than the company is earning. Then again, it could mean that the market expects the company to perform extremely well in the future. With a low P/E ratio, the company could be undervalued. Or, it could currently be performing better than expected.
Some may compare the P/E ratios of companies to determine which is a better investment. A lower P/E might indicate a better bang for the buck. A higher P/E may be attractive to investors looking for high risk/high reward scenarios.
What does all this mean for me?
Well, don’t rely on P/E ratios alone. As this quick discussion shows, the numbers can be interpreted in many different ways. P/E ratios are helpful when used with other statistics to assess a company. And you do want to assess a company before investing. There is no one rule that applies to every situation. So, you should do as much research and reading as you can. Or, you can consult with a trusted financial expert like Richard Cayne for advice on what stocks and other investments are right for you.