P/E Ratio

The P/E ratio, or price to earnings ratio, is one of the most essential ratios used in fundamental analysis when determining if a stock has potential for growth or if it should be avoided. 

You may have questions like,

So what exactly does the P/E ratio do? How do I calculate it? How can I use it to determine whether to buy a stock or not?

Let’s take an in-depth look at What Is the price to earnings ratio and how to use it in our investments through these topics,

1. Introduction to Price to Earnings Ratios
2. The Formula for the Price to Earnings Ratio
3. The Advantages of P/E ratio
4. Limitations of Fundamental Analysis
5. Practical Examples
6. Key Takeaways from Fundamental Analysis

A Quick Introduction to Price to Earnings Ratios

There are a lot of different kinds of stock valuation ratios out there, but one of the most common is the price-to-earnings (P/E) ratio. 

P/E ratio measures how much an investor must pay to acquire $1 in company earnings—it’s calculated by dividing a company’s share price by its earnings per share. 

The Formula for the Price to Earnings Ratio

There are a number of ways to calculate the price to earnings ratio, but we’ll stick with one of the simplest: earnings per share divided by stock price. 

For Our calculations let’s Introduce you to a new imaginary company Club Ltd.(Of Course we will be on the Stock Exchange on Day)

For example, Club Ltd (Our Imaginary Company) has earnings of $100 billion and has 10 billion shares out there, its Earning per Share value(EPS) is $10. 

EPS= Total Revenue/Total shares

Now, If its stock is trading at a price of $100, its PE ratio would be $100 divided by $10, which comes out to 10. 

P/E = Share price/Earnings Per Share

If we say that in normal terms the stock is trading 10 times higher than the company’s earnings.

The Advantages of P/E ratio

To determine whether a stock is undervalued or overvalued, investors compare its P/E ratio to similar companies in its industry or sector.

Let’s say, Club Ltd company has an average  P/E ratio of around 20—meaning that on average, investors think and are willing to pay Club Ltd stock for a higher price because Club Ltd will grow their profits by about 20% over time.

 If you’re comparing two stocks with similar growth prospects but different P/Es, go with the cheaper one—you’re getting more charge for your money.

The Pros and Cons of Using Price to Earnings Ratio: A low price-to-earnings ratio means that investors believe there’s lots of room for growth because they’re paying less than what they think those future earnings will be worth.

Limitations of Fundamental Analysis in P/E ratio

One of the most common ways that investors analyze potential stocks is by using fundamental analysis. That’s where you look at a company’s fundamentals: its revenues, earnings, assets, market share and so on. 

You can also use a stock screener to find companies with low PE ratios or high dividend yields. But there are two big limitations to fundamental analysis. 

First, it doesn’t consider how much investors are paying for a stock versus what they’re getting in return. Second, it doesn’t consider whether people will want to buy a company’s products in five years’ time. 

So let’s take a closer look at these two problems…

The first problem with Fundamental Analysis is that it only looks backwards – how much money did your business make last year? What was your revenue growth over the past five years? And so on. 

While those numbers may be important for businesses, they don’t tell us anything about what will happen next year. To find out, we need to look at a company’s future expectations, which leads us to our second problem…

The second big limitation of fundamental analysis is that it doesn’t consider whether people will want to buy a company’s products in five years’ time. This isn’t just a theoretical concern: 

Practical Examples

Coca-Cola has been around since 1886 and Kellogg’s since 1906, but both companies have seen their revenues decline in recent years because consumers are buying less soda and cereal. As a result, they’ve had to adapt by selling more healthy drinks and snacks. 

By contrast, look at Amazon, which was founded only in 1994. While its revenue growth has slowed down over the past few years, it still generates huge amounts of cash flow thanks to its loyal customer base. This means that investors can expect solid returns for many more decades. 

In other words, fundamental analysis can tell you how much money your business made last year or how much profit you’ll make next year. It won’t tell you if your business will be around for another 50 years! 

Key Takeaways from Fundamental Analysis in P/E ratio

If you’re new to fundamental analysis, here are some key takeaways. First, check out a company’s balance sheet and cash flow statement. What is its debt level like?

Second, look at how much profit (or net income) it is making (if it has a positive net income), what its net margin is, and how fast it is growing (if you’re examining revenue). 

Then, use the ratios that can help you compare your stock with another company or market index: price-to-earnings ratio (P/E ratio), price-to-book ratio (P/B ratio), dividend yield, etc. 

Author’s Disclaimer

Finally, if you want to get more advanced, you can try some other factors other than ratios and Charts. 

You can use valuation techniques such as discounted cash flow (DCF) models. These models take into account a company’s future earnings potential when estimating its current value. 

You might also want to consider using other financial metrics such as return on equity (ROE), return on assets (ROA), etc., which measure profitability in different ways than net income does.