One of the most important parts of researching stocks as an investor or trader is understanding the value of the stock you’re looking at.
Like with any purchase, it’s important to know how expensive something is so you know if you’re getting a good deal or not.
One of the most common measures of stock value is the price-to-earnings ratio, or P/E ratio.
In this post, I’ll explain what the price-to-earnings ratio is, how it’s calculated, and what it means for investors. I’ll also show you how to use the P/E ratio to find good investment opportunities in the stock market.
Let’s get started!
What is the P/E Ratio? What Does It Mean?
The P/E ratio (price-to-earnings ratio) is a measure of the price of a stock in relation to the total earnings (i.e. net profit) of the company.
To calculate the P/E ratio, you divide the current price of the stock by the earnings per share (EPS) of the company. For example, if a company’s stock is trading at $100 per share and the EPS is $10, the P/E ratio would be 10 ($100/$10).
The P/E ratio can be a useful tool for investors because it provides insight into how much people are willing to pay for each dollar of earnings.
- A high P/E ratio means that investors are paying more for each dollar of earnings, which may indicate that they believe the company will have strong future growth.
- A low P/E ratio means that investors are paying less for each dollar of earnings, which may indicate that the stock is undervalued.
It’s important to keep in mind that the P/E ratio is just one factor to consider when making investment decisions. It’s also important to look at other factors such as the company’s business model, competitive landscape, and financial stability.
NOTE: If you’re curious why the P/E ratio is a good way to quickly estimate the value of a company, check out my follow-up post Using The P/E Ratio for a Valuation Estimate: An In-Depth Explanation
How to Use the P/E Ratio to Find Good Investment Opportunities
There are a few different ways you can use the P/E ratio when researching potential investment opportunities.
Comparing P/E Ratios Of Similar Companies In The Same Industry
One way to use the price-to-earnings ratio is to compare the ratios of similar companies in the same industry. This can give you a good idea of whether a particular stock is undervalued or overvalued relative to its peers.
For example, let’s say you’re considering investing in Company A and Company B. Both companies are in the same industry and have similar business models.
Company A has a P/E ratio of 20, while Company B has a P/E ratio of 10. This means that investors are willing to pay $20 for each $1 of earnings for Company A, but only $10 for each $1 of earnings for Company B.
This could mean that Company B is undervalued relative to Company A. Of course, you would still need to do additional research to confirm this before making any investment decisions.
One good example of this was back in August 2021, when Tesla was splattered all over the news and media, and hailed as one of the hottest stocks to buy. But when comparing Tesla’s price-to-earnings to many other car manufacturing stocks, it was clear that Tesla was very expensive.
At the time, these were the P/E ratios of the major car manufacturing stocks in the United States:
- Tesla (TSLA) = 371.17
- Ford (F) = 16.44
- General Motors (GM) = 9.22
- Toyota (TM) = 9.01
As you can see, Tesla’s P/E ratio was over 20 times that of Ford, GM, and Toyota. This meant that investors were willing to pay $371 for each $1 of earnings for Tesla, but only $16-$9 for each $1 of earnings for the other companies. This indicated that Tesla was very expensive relative to its peers, and might not be a good investment at that time.
Of course, Tesla’s stock has gone up even more since then, so if you had invested in Tesla back then, you would have made a lot of money – but this is an atypical event, largely driven by media hype rather than strong financials. Things could have just as easily gone the other way if the news and media wasn’t as favourable towards Tesla – and that’s something no one can really predict.
Rather, it was a gamble that happened to pay off.
Comparing P/E Ratios Of The Same Company Over Time
The P/E ratio can also be used to compare a company’s stock price to its earnings over time. This can give you some insight into whether the stock is currently overvalued or undervalued.
For example, let’s say that a company has consistently had a P/E ratio of 15 over the past few years. But today, the stock price has increased and the P/E ratio is now 25.
This could mean that the stock is currently overvalued and may be due for a correction (i.e. the stock price will go down). Again, you would need to do additional research to confirm this before making any investment decisions.
Using the P/E Ratio as a Quick, Rough Guide of How Expensive a Stock Is
Generally speaking, a high P/E ratio indicates that a stock’s price is relatively expensive, while a low P/E ratio indicates that it is relatively cheap.
There is no set “threshold” for what is considered a high or low P/E ratio, but typically, companies with P/E ratios below 20 are considered to be relatively cheap, while those with P/E ratios above 40 are considered to be relatively expensive.
Of course, there are always exceptions to this rule, as different sectors and industries have different “normal” P/E ratios. For example, growth companies tend to have higher P/E ratios than value companies.
This is because growth companies are expected to generate higher earnings growth in the future, so investors are willing to pay more for each $1 of earnings today. Value companies, on the other hand, are typically mature companies with slower earnings growth, so investors are willing to pay less for each $1 of earnings.
Don’t Make This Common Rookie Mistake – Using P/E For Stock Valuation
It’s worth noting that the P/E ratio is just one metric you should look at when evaluating a stock. It’s important to do your own research and not just rely on this single number. The P/E ratio should only be used as a rough guide of how expensive a stock is.
A common mistake that investors make is using the P/E ratio in isolation to value a stock. This is a highly flawed approach.
To put it simply using a metaphor, using the P/E ratio to determine a stock’s value is like buying a “Medium-sized” pair of jeans.
What does Medium actually mean? “Medium size” is a subjective measurement that can be very different depending on the country of production or clothing brand.
On the other hand, having specific measurements for your waist size and leg length in standard centimetre units is an objective way of looking at what is actually needed for a proper fit.
And that’s exactly what a good valuation tool does – it looks at the unique financial situation of each company to determine what its actual value is.
Like I always mention to my Blueprint students, “rubbish in, rubbish out” – your ability to make good decisions relies heavily on how accurate your information is.
So for this reason, I don’t like to use P/E ratios as a method of valuing stocks. Rather, I’ll just use it as a quick gauge of how expensive it is.
The P/E ratio is a popular measure of stock value, but keep in mind that it’s just one factor to consider when making investment decisions.
While it can give you a snapshot insight into how expensive a stock is, it’s important to use it in conjunction with other investment metrics to get a more well-rounded view of a potential investment.
If you’d like to learn what those other investment metrics are, I’d like to invite you to my free 90-minute Online Masterclass, in which I’ll show you
- and how to analyze stocks using the 4 financial figures that matter the most in less than 5 minutes
- how you can use just 1 metric to help you anticipate the potential future of the market and make preparations ahead of time
- how you can figure out when to time your stock market entry and exit (using my straightforward ‘traffic light’ process)
It’s a highly interactive class complete with your own downloadable workbook, and I guarantee you’ll walk out of the Masterclass with a completely different lens of the trading and investing world.
The best part of it is, you won’t just be sitting there absorbing information – I’ll be getting you to apply what you learn on the spot so you can leave the class with newfound confidence in your trading and investing strategy.
If you’d like to join me, book your spot here, and I’ll see you on the other side.