What Does P/E Ratios Mean In The Stock Market

To evaluate how cheap or how expensive a stock is at any given moment, the price to earnings or P/E ratio may be used. P/E ratios can be used to determine the fair market value of stock or company, just like an appraiser can give you an estimate of the value of your home.

To calculate the price to earnings ratio, you divide a company's current stock price by its earnings per share (EPS).

Why P/E Ratio Is Important

A company's P/E ratio can be indirectly viewed as a measure of future growth and risk. These factors are generally taken into account in its calculation:

• Performance History
• Risk & Debt
• Future Growth
• Management & Corporate Governance
• Dividend Payments
• Economic Cycle

How To Use P/E Ratio

An estimate of stock valuation is commonly calculated by using the price-to-earnings ratio, or P/E ratio. Along with indicating whether a stock is overvalued or undervalued, the P/E ratio can reveal how a stock's valuation fits within a benchmark or other companies.

Investors calculate the P/E ratio by comparing a stock's market value to its earnings. A stock's P/E ratio can be summarized as a reflection of what the market is willing to pay based on its current earnings compared to its earnings in the past or in the future. A high price to earnings ratio indicates that a stock is likely overvalued, since it is perceived as being expensive relative to earnings. If the P/E is low, the current stock price may be low compared to earnings, and thus a good value.

Pros and Cons Of P/E Ratio

Pros of P/E Ratio

• Calculated easily; most stocks have available data on this indicator
• Investors can use it to estimate a stock's value rather quickly
• A comparison tool that helps investors compare stocks, industries, indexes.

Cons of P/E Ratio

• Provides only a broad analysis of a stock, not a thorough one
• Depending on the accounting practices used, could be manipulated
• The figures are based on historical earnings, so they may contain inaccuracies
• Ignores debt and cash

What Does High or Low P/E Ratio Mean?

There are two possible interpretations of a high P/E ratio. In this case, it could be an indication that the market overvalues a company's stock or that it expects it to do well.

Accordingly, a low P/E ratio can indicate a couple of important things. The market either undervalues a stock or forecasts poor performance for the future.

Various analysts might interpret P/E ratios differently. The same ratio may be interpreted differently by different analysts as an indication that the company is overvalued, or as a signal that the company is likely to succeed.

Many analytes place different weights on different factors in different circumstances, so their views often differ. When evaluating stocks, every investor must decide for themselves how to interpreted P/E ratios, among other metrics, in accordance with his or her own set of rules.

P/E Ratio Is Just A Tool

The P/E ratio is talked about a lot in articles, online and on TV whenever people are talking about stocks. It seems to be the go to metric that people quickly jump to when trying to value a company or stock. It is a useful tool but not a perfect tool or the only tool. The P/E should never be the only reason for why you are investing in a stock, you should be looking deeper than that and certainly reading the quarterly reports, balance sheet etc. You should also be using other valuation tools and metrics such as price to book (P/B), price to sales (P/S) just to name a few.

So if this is the only tool in your toolbox then I would highly recommend that you do more reading and research and educate yourself on how to properly evaluate and value stocks.

As always this article is not intended as financial advice in any way. Before you make any financial decisions you should always seek out professional financial help.