P/E is also called Price-Earnings ratio. This term is something you may have heard of when looking at terminologies related to the economy and buying stocks, but you might not be sure what it really means. In this article, we’ll explain what the term means, and the advantages and disadvantages of Price-Earnings ratio.
This ratio is used to value a company by measuring its share price relative to the earnings it makes per share. It can also be known as the price multiple, or the earnings multiple. It is estimated by dividing the current price or trading price of the stock by what it earns per share, or EPS.
The Advantages of Price-Earnings Ratio
The Price-Earnings ratio of a company can be a good indicator to potential buyers of the stock. If a stock has a low Price-Earnings ratio, it can be considered a potentially a good buy, as the potential for its growth is unknown (this could also be a disadvantage).
If a company has a high Price-Earnings ratio, it potentially means that the stock is over-priced. In other words, the price of the stock is higher than the potential for its growth, so there’s a good chance that the stocks may crash spectacularly. This happened in the credit crunch of the late 2000s when markets crashed all around the world.
Investors with a good eye for detail will take heed of this and sell their stocks before there’s a crash in stock prices.
The Disadvantages of Price-Earnings Ratio
It needs to be remembered that a Price-Earnings ratio is not the be all and end all. There are many factors that come into play when analysing the financial health of a company.
Also, it should be borne in mind that the Price-Earnings ratio in some industries is naturally a lot higher than in other industries. An example of this would be companies in telecommunications and IT. They generally have higher Price-Earnings ratios than companies in manufacturing, for example.
Something else to take note of is that there are certain events that will naturally increase a company’s Price-Earnings ratio; a major announcement or a company takeover for instance. Additionally, a low Price-Earnings ratio may not always mean it’s a good idea to buy shares; it can indicate that something is wrong with the company. Therefore, it is always important to do a lot of background research into a company before you take the plunge and invest your hard-earned cash.
Finally, Price-Earnings ratios largely forecast growth for the future based on a company’s past performance. But in this current volatile economy in which we find ourselves, there’s no guarantee that there won’t be unexpected events or that a company will be able to maintain its performance. There could be problems. Therefore, the Price-Earnings ratio cannot be totally relied upon as a signifier of cheap, value-for-money stocks to buy.
However, all things considered, the Price-Earnings ratio is still one of the best indicators out there when you’re looking for those bargain stocks to pick up. Just be sensible!