Profitable companies do not necessarily make a good investment. There are all sorts of financial ratios and investment analysis measurements that contribute to the selection of stocks as investments with high return prospect. It also depends on the investor profile and the level of risk that an investor is willing to undertake. One of the most widely used ratios in stock selection is the price-to-earnings ratio (P/E), which assesses the stock price in relation to the company’s earnings.
Understanding the P/E ratio
The price-to-earnings ratio (P/E) is a relative valuation metric that compares a firm’s stock price to its earnings to determine how investors think of the firm’s financial performance and growth prospects. P/E provides an idea of how much investors are willing to pay per dollar of reported earnings. For instance, if a stock currently trades at $88 and earnings per share (EPS) is $2.06, the P/E ratio is $88 / $2.06 = $42.72. This suggests that investors are willing to $42.72 per dollar of reported earnings.
Calculating the P/E ratio
Financial analysts calculate the trailing P/E using the EPS of the last 12 months or the forward P/E using the estimated EPS for the next 12 months. A third approach is to use the EPS of the last six months and the estimated EPS of the next six months. In fact, there isn’t a huge difference between these variations. The only difference is that the calculation of the trailing P/E is using actual historical data, while the other two methods use estimates of future growth that may be inaccurate or even biased.
Assessing the P/E ratio
Generally, a high P/E suggests that the market is bullish about the company, expecting that it can grow further. Conversely, a low P/E suggests that investor confidence in the company is low. By taking into account how fast a firm has been growing, analysts seek to determine if its projected growth justifies the price-to-earnings ratio. There are stocks that trade above their fair value as well as stocks that trade below their fair value. A high P/E may be an indication of an overvalued stock. Therefore, analysts always compare a firm’s P/E to the industry average or to similar companies in the industry to determine if a stock is overvalued, undervalued, or fairly valued. Also, each industry is driven by different dynamics and has different growth prospects. Therefore, it doesn’t make sense to compare the P/E of a technology firm to the P/E of a retail company.
A Quick Example
Company A is a leading technology company. Its stock currently trades at $52.5 and has an EPS of $1.94. The company’s P/E is $52.5 / $1.94 = $27.06. Company B is a smaller technology company that operates in the same industry. The stock of Company B currently trades at $61.33 and has an EPS of $1.21 The P/E of company B is $61.33 / $1.21 = $50.69.
By simply looking at the P/E ratios, you would conclude that Company B is a better investment than Company A. However, as a financial analyst, you should go your analysis deeper by analyzing the fundamentals of the two companies. What is the debt-to-equity ratio? What are their assets and liabilities? Do they generate high profits? Is their stock price justified?
In conclusion, the P/E ratio provides information on a firm’s historical performance and/or expected growth. However, to determine the worthiness of an investment, analysts should go further than the market optimism reflected on a firm’s P/E ratio, and base a buy or sell decision on the firm’s fundamentals.
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