102-20 Price Earning Ratio

Price Earnings Ratio – P/E Ratio

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

Now that we understand there are different types of 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 have the ability to repay that debt easily, 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 additional insight.

PE Ratio. 16 Easy Steps to Price-Earnings Ratio Mastery

Is the company reasonably priced?

The Price to Earnings ratio is a simple calculation that may take some 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 buy 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 five 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 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 is 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 were 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 underperformer / or a stock with potential value. If the earnings suddenly jumped for this stock, this could potentially be a good bargain.

The P/E Ratio needs to be combined with other fundamental measures to get a better picture of the stock.