CapitalistLAD Guide to Ratios: P/E Ratio

New to investing? The P/E Ratio is one of the most common ratios used by investors and speculators when choosing a stock.

 

What is the P/E Ratio:

P/E is short for Price to Earnings. It is calculated by dividing the price of the share by the past year’s Earnings Per Share (EPS) of the stock. (e.g. Price of stock is $20. The company earned $1.50 in the past year per share. P/E = 20/1.5 = 13.3) It can also be calculated by dividing the Market Capitalisation (price times the total number of shares) by the Total Earnings of the stock in the past year.

 

Why should I use the P/E Ratio:

The P/E Ratio is commonly used as a basic indicator to determine if the stock is expensive or if it is a good bargain. Typically, you would compare the P/E Ratio of the stock you are looking at to the P/E ratios of other companies in the industry or sector. For example, let’s say you’re deciding between Sing Holdings (SGX:5IC) and Yanlord (SGX:Z25). Sing Holdings has a P/E Ratio of 21.42 and Yanlord has a P/E Ratio of 5.39. What does this mean? Basically, it means that it is more expensive to buy Sing Holdings than Yanlord because you are paying 21 dollars for every dollar of Sing Holdings’ earnings compared to the 5 dollars you pay for 1 dollar of Yanlord’s earnings.

If you are still confused, imagine buying a machine that would give you a $100 a year. One machine costs $2100 and the other $500, ceteris paribus, which one sounds like the better deal? Of course, the one that costs $500!

Another way of looking at P/E ratios is how many years it’ll take you to “earn” your initial investment back. If you put in $500 for something that produces $100 a year, how long will it take for you get back your original investment? 5 years. The same as the P/E Ratio.

 

Disadvantages of the P/E Ratio:

The P/E ratio can easily swing either way when the earnings are released. A bad quarter can change the P/E Ratio dramatically. If the stock is $10 and the earnings for the last year totalled 0.5+0.5+0.5+0.5 = 2, the P/E ratio would be 5. But let’s say there was a 0.5 earnings loss per share in the latest quarter, the new P/E ratio would then be 10 (10/ (0.5+0.5+0.5-0.5)). As you can see, the P/E ratio is based on past results and it is important to consider what the future earnings of the company are going to be like.

Although the P/E ratio may seem very useful, please don’t just look at this ratio alone. It is important to use it alongside other ratios and your form your own opinion about the future of the company. If you have any thoughts or questions, please do ask us in the comments section below.

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5 thoughts on “CapitalistLAD Guide to Ratios: P/E Ratio

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