Using P/E Ratios
The price/earnings (P/E) ratio is the price you pay for $1 of a company’s earnings. For example, if a company reports basic or diluted earnings of $2 per share and the stock is selling for $20 per share, the P/E ratio is 10 ($20 per share divided by $2 of earnings per share). This ratio helps you determine if a stock is over or undervalued, helps compare companies in the same industry, and helps to compare the return you are actually earning from the company compared to other investments, such as bonds or real estate. Here’s how it works. Both company A and B are selling for $50 per share. Company A has reported earnings of $10 per share, and company B has reported earnings of $20 per share. Company A’s P/E ratio is 5, while company B's is 2.5. Company B is cheaper and providing twice the earning power because for the same share price, an investor is getting $20 of earning as opposed to $10 of earnings. There are also variances in P/E ratios by industry, because there are different expectations for different types of business. Technology companies typically sell at larger P/E ratios, because their growth rate and earnings are higher. The bottom line is you have to do your homework. If you want to buy a stock because it has an attractive P/E ratio, make sure you know why. It may be a great stock to purchase and is just undervalued, but make sure you know if the company is losing business or is poorly managed. It may also be that the entire industry is weak. Don’t just buy a stock because it’s cheap. Many investors also use the price/earnings to growth ratio, also known as the PEG ratio, because it also factors in the growth rate of a company.
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