Methodology

Stocks

Module 1

Price-to-Earnings Ratio

The price-to-earnings ratio is a commonly used ratio that measures the value of a company in relation to its earnings.

It is useful because it enables investors to quickly see whether an investment is worthwhile or not. The price-to-earnings ratio helps investors to save time by not wasting time researching a stock that is likely to be too expensive or too cheap for their risk tolerance. 

Many investors have a limit on how much they are willing to spend on an investment, in relation to its earnings.

A high p/e ratio may be seen as a risk to an investor, as the earnings of the company are so much lower than the market value of the company (stock price).

At the same time, a low p/e ratio may seen as a big opportunity to an investor, as the earnings of the company are almost as much as the company is worth. This could indicate that the stock is under-valued.

Calculating the P/E ratio

The P/E ratio is calculated using the following formula.

P/E=\frac{\text{Share price}}{\text{Earnings per share}}

As you can see, it is a simple calculation that involves dividing the share price of a company by its earnings per share.

For instance, a company with a share price of $100 and earnings per share of $20, would have a P/E ratio of 5.

The p/e ratio is usually given for you when you look for information on a stock. However, it is necessary to understand how it is calculated, in order to fully understand what it is really telling you.

It is a ratio that tells you, as a multiple, how much you will be paying for a stock in relation to the earnings.

What is a good P/E ratio?

The standard price-to-earnings ratio is 20, meaning that investors typically find it acceptable to buy a stock at a price that is 20 times more than the earnings of the company. So if a company makes a $1 profit, then an investor would be willing to invest at a price of $20.

With that said, an acceptable price-to-earnings ratio tends to vary from one industry to another.

Investors are usually more willing to invest at a higher ratio in industries like technology, while preferring to accept a lower ratio in other industries, like banking.

For instance, Tesla currently has a price-to-earnings ratio of 202 (as of April 2022), while J.P. Morgan has a ratio of just 8.5 (as of April 2022).

Whether the p/e ratio for Tesla or JP Morgan is abnormal, depends on the p/e ratio of other stocks that operate in the same industry.

These differences allow investors to easily compare different investment opportunities within the same industry. If one company has a lower price-to-earnings ratio than the average for that particular industry, then it could be a buying signal.

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