Tuesday, July 29, 2008

What is P/E Ratio and How to Calculate P/E Ratio

If you are an investor in the stock market, I am sure you will know what is P/E Ratio. If you do not know about it, then it would be quite dangerous to go into stock market. In my opinion, P/E Ratio is the most basic that all investor should know before investing in stock market.

So, if you do not know or have less idea about P/E Ratio, this post might be helpful for you to learn some knowledge about stock market.

What is P/E Ratio:

P/E Ratio is Price per Earning Ratio. It is one of the important ratios in fundamental analysis. Some people denote Price per Earning ratio as P/E ratio, PE ratio or PER. So, do not get confuse if other people are using different notation for Price per Earning ratio. In this post, I will use P/E ratio and I hope you will not get confuse.

P/E Ratio gives us quite a lot of information when we are analyzing a stock. By referring to P/E ratio, we can know how many times we are paying for a stock.

The formula of P/E Ratio:

P/E = Price of stock in market/earning per share

**Price of stock in market: Can be obtained in newspaper or trading platform.

**Earning per Share: Can be obtained in financial report of the company. Some trading platform offers this information.

For example:

A stock which is selling at $5.00 have earning per share of $0.50.

The calculation will be: P/E = $5/$0.5 = 10.

From the example above, we can see that the P/E ratio is 10. This means that the price of $5.00 is 10 times larger than the current earning power of the company.

Therefore, if the earning per share of the company remains unchanged every year, investor will need to wait 10 years to get the earning of the company equal the buying price. It is noted that the P/E ratio is rising according to the stock price.

For example: If company is earning $0.50 every year, it would take 10 years for investor to get their investment back.

So, a lot of people are looking for company with low P/E ratio because lower P/E ratio means we get our investment back in shorter period of time.

Different People Have Different Interpretation on P/E Ratio:

Please look at the example below:

Company A: Price of stock = $8.00 & Earing per share = $2.00.

Company B: Price of stock = $10.00 & Earning per share = $1.50.

From the detail above, we can calculate that Company A has P/E ratio of 4 while Company B has P/E ratio of 6.67.

Some people will buy stock of Company A because they think that buying at $8.00 with earning per share of $2 and P/E ratio of 4 is a great deal because investor can get their investment back faster.

Some people will go for Company B because they think that high P/E ratio is better because usually large company have larger P/E ratio and can generate more attractive returns.

So, high or low P/E ratio? It depends on your investment risk. If you can take higher risk, then go for low P/E ratio of smaller company. Bear in mind that when market crash, smaller company will have higher risk of financial problem. So, if you don't like risk, the go for larger P/E ratio, those larger company. I don't like risk, so I go for large company with acceptable P/E ratio.

My Personal Use on P/E ratio:

I use P/E ratio in the reverse manner. You can see the formula is:

P/E = Price of stock in market/earning per share

I just rearrange the formula and get the formula below:

Price of stock in market = P/E ratio * Earning per share

I will go to get the latest information for P/E ratio and earning per share and put values in the formula above.

Normally, the latest information can be obtained from websites or platform. By using these details, I can predict the value of stock for tomorrow.

For example:

The new P/E ratio is 10 and earning per share is $1.00. So, I know that the stock price will be $10.00. So, if the stock price of the company I analyze is selling lower than $10.00, it would be a great time to buy.

Of course, I do not based solely on P/E ratio. I will check other ratios such as ROE, profit margin, Earning Per Share growth rate, debt to equity ratio, MACD, RSI, Bollinger bands and so on. I will discuss about them in the coming posts.


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Sam Stone said...

Great lesson on P/E ratios. Heard it all the time on CNBC but glad finally someone could explain it in depth!

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