P/E Ratio

The price-to-earnings ratio ("P/E" or "earnings multiple") is a number that compares a company's stock price to its earnings per share (EPS). For investors, the P/E ratio shows what the market is willing to pay for a stock based on its earnings.

How can I use P/E ratio when I invest in stocks?

• You can use the P/E ratio to determine if a stock is overpriced (if the P/E ratio is high) or undervalued (if low) versus similar companies in its region and industry. For example, Alibaba currently has a P/E ratio of 30.8 compared to its industry average of 31, while Amazon, also from the same industry, has a highly inflated P/E ratio of 121.1. A value investor would reason that Alibaba is the more attractive investment option as it has a higher upside potential compared to Amazon.
• However, it does not necessarily mean that an overvalued stock is a poor investment, as slightly overvalued stocks like Apple, Google and Microsoft are companies that continually innovate. Their higher-than-average P/E ratio could mean that investors are willing to pay a higher price for their shares due to their high growth potential.
• You can also make use of the P/E ratio, specifically the forward P/E ratio to predict earnings growth. There are two types of P/E ratio: trailing P/E, which represents current stock price divided by earnings per share for the last 12 months and forward P/E, which means current stock price divided by expected earnings per share for the next 12 months. If you observe that a company's forward P/E is lower than its trailing P/E, it means that its earnings are expected to increase over the next 12 months. This is also another indication that stock price may increase too.

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