This is an excerpt from the Liberated Stock Trader Book and accompanying Training Course. Chapter 4 – Section 4 – The P/E Ratio

Now that we understand there are different types or stocks or companies out there we can take a look at how to fundamentally evaluate if a business is healthy or not.  Having some knowledge that a company will not be declaring bankruptcy anytime soon is the minimum goal, however the more refined investor will be looking for stocks that are reasonably priced, have low amounts of debt or at least the ability to easily repay that debt, strong sales growth or revenue growth, a decent amount of cash in the bank, and solid earnings.  Also, if you are familiar with the company’s product and how important that product is to the business can give you an additional insight.

Is the company reasonably priced? The P/E Ratio

The Price to Earnings ratio is a simple calculation that may take a little bit of time to understand.  But once you have it, it can be very useful.  The P/E Ratio is the Share Price divided by the earnings.

Let us imagine I want to by an Ice-cream Stand.  The Owner wants to sell that stand to me for $10,000.  I have estimated a yearly profit (after tax) of $2,000.  This means it would take me 5 years to make my money back on this investment.  Therefore the Price I paid divided by the earnings equals 5.  This is what the P/E Ratio or the “Multiple” tells us.  In the example above I used the example of buying a whole business and we are considering all of the profits.  The P/E Ratio achieves this same goal by using the Individual Share Price / Earnings per Share.

The P/E Ratio can tell you what kind of premium investors are willing to pay to get a piece of this company.   P/E Ratios should always be considered in the context of the industry group.  For example compare the P/E of companies in the same industry, this will tell you which companies are perceived to have the brightest future or the best products or services as the investors are willing to pay more for a share of one company as opposed to another company that are in the same line of business.

Company A – P/E 50 – If 50 is the highest PE in the industry then people believe this company has the best profit growth potential in the future.

Company B – P/E 25 – If 25 was the industry average then this company would be seen as a fairly priced stock for the industry.

Company C – P/E 5 – This company would be seen as an under performer / or a stock with potential value.  If the earnings suddenly jumped for this stock this could potentially be a good bargain.

The PE Ratio needs to be combined with other fundamental measures to get a much better picture of the stock.

The article goes on to discuss how important the P/E Ratio is when you use it to view the P/E of an entire Market using the S&P Composite as a reference, and enabling you to really understand historically if a market is overpriced.  Absolutely critical knowledge.

Name: Barry D. Moore

Bio: Certified Technical Analyst (Stock Market Technical Analyst), Full Member of Society of Technical Analysts (STA) Level II CFTe (Certified Financial Technician), independent trader, author, trainer & blogger.

Other Chapter excerpts from the Liberated Stock Trader Book & Training Course are here :

Chapter 1 – Essential Stock Market Knowledge – Fundamentals

Chapter 2 – Why do Booms and Busts Occur?

Chapter 3 – Stock Market Cycles – Business & Economic Cycles – Kondratieff to Kuznets

Chapter 4 – Is the Company in great shape – P/E Ratio

Chapter 5 – How to find the best stocks

Chapter 6 – Japanese Candlesticks – Bullish Reversal Patterns

Chapter 7 – How to draw trend lines

Chapter 8 – ROC Rate of Change Indicator

Quick Stock Market Tips and info.