Any investor who wants to make smart investments considers several factors to score the best possible deal. A company’s stock price and its PE ratio provide great insight into whether the time to purchase a given stock is appropriate.
Is a Stock’s PE Ratio Important?
The price-to-earnings ratio is important because it gives a glimpse of how much investors are ready to pay for every dollar of earnings. In simple words, a high PE ratio suggests that investors can expect higher earnings. A stock with a high PE ratio value offers better investment opportunities than one with a lower PE ratio because a high ratio indicates that the stock is overvalued. However, investors can risk losing money if the overvalued stock does not meet their high earning expectations.
On the contrary, the low PE ratio of a company indicates that the stock is undervalued. Many times, investors buy a low PE ratio because they can purchase undervalued stocks at a discount to earn profits when the stock price increases. However, investors should also remember that a low PE ratio indicates a genuine lack of growth potential in some cases. For that reason, comparing a company’s PE ratio with that of similar companies in its niche can sometimes help to evaluate whether the stock you are purchasing is undervalued or overvalued.
How to Calculate PE
To calculate the value of the PE ratio, we divide the stock’s current price by EPS or the earnings per share. Besides helping you determine whether a company’s stock price is undervalued or overvalued, the ratio also reveals how a stock’s value compares to a benchmark like the S&P 500 Index.
PE Ratio: The Downside
Just like any other metric that allows investors to make informed decisions, the PE ratio also comes with a few limitations, leading investors to misjudge a stock’s value.
Companies that are not generating significant profits have negative earnings per share. Hence, when it comes to calculating their PE, their opinions may vary on dealing with this situation. Some companies would say that they have a negative PE, while others may assign zero value for their PE ratio. Investors may also come across terms such as ‘not available’ or ‘does not exist.’
A primary limitation of using PE ratios surfaces when investors compare this metric of different companies. Growth and valuation rates of companies usually vary wildly between sectors because of the different ways through which they earn money. Another factor that affects this comparison is their differing timelines. For that reason, PE ratios are generally useful for analyzing blue chip slow-growth companies. By a blue-chip stock, we mean a stock that comes from an already established company.
At IES, we develop high-return and low-risk investment systems for allowing you to increase your return on your market investments. Since we invest in ‘growth stocks,’ we ignore PE ratio stats when analyzing investment candidates. Get in touch with us to find out more about helping you generate more profits on your investments.
Island Equity Systems designs and markets equity trading systems for the personal investor