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.
Debt to Equity Ratio
Used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity.
Profit is the financial benefit realized when revenue from a business is higher than the costs and taxes involved in operating that business.
Alternative investment class composed of funds that invest directly in private companies or that buy public companies and take them private
Time of declining economic activity, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and sales.
A stimulus package is a coordinated effort by the government to increase spending and investment to "stimulate" an economy out of a downturn.
Shorting a stock
Trading strategy that tries to take advantage of the decline in a stock price by borrowing a stock and sell it now while planning to repurchase it later for a lower price.
Market-capitalization-weighted index tracking the performance of the 500 largest U.S. companies