p/e ratio

Why Is the P/E Ratio Important

Hello Investors, today I’m going to talk about, The price-earnings ratio ( p/e ratio ).

One of the most common numbers when it comes to investing in the stock market. We’ll take it back to basics and explain exactly what the p/e ratio is.

How it helps us understand the value of shares in a particular company, I hope you enjoyed this post and learned something new.

Table of Content

let’s get into it, in this post I will cover just a basic breakdown of the p/e ratio, and what it means for us as investors in this day and age.

p/e ratio meaning

what is the p/e ratio? well, it is by far the most commonly used number. it tries to help us value shares of a particular company.

It’s essentially the share price divided by the current earnings per share

Essentially what it’s telling us?

The p/e tells us what the multiple of the earnings per share is,

investors willing to pay a share price for that company.

A company with a p/e ratio of 10 means that investors out there, are willing to pay

ten times the earnings per share of that company, for the share price.

Overall how does the p/e ratio actually help us?

We can look at some historical figures and rough averages as to what people usually pay for p/e ratios.

Then we can look at whether some companies are cheap or expensive and go from there.

If you look at the averages usually you probably see a p/e ratio of somewhere between 16 to 20.

Once you start getting into the P values that are like 30, 40, 50

that’s where the share price is way too high, for the actual underlying earnings of that company.


What is a good p/e ratio?

A low price-earnings ratio (P/E) of 5 or 10 indicates that the company is very cheap at the moment.

Because the earnings per share are pretty good. but the share price is very low.

Overall if you look at the S&P500 roughly throughout history,

you’ll get an average p/e value of between 16 and 18.

When you’re looking at private companies you will actually trade for a lower p/e ratio and that’s because harder to sell your stake in a private company. Investors are going to get a better deal if they invest in a private company as opposed to a public company listed on an exchange.

Retail investors can log into their brokerage accounts and easily buy and sell stocks. They will be willing to pay a little more for their shares, which will mean a higher price-to-earnings ratio.

p/e ratio

p/e ratio

Different p/e ratios

what do the different p/e numbers mean?

Low p/e ratio

If we just look at the formula, the low P/E ratio means that

the stock price is low and the earnings per share are pretty good.

High p/e ratio

A high p/e means that the share price is very high,

and the earnings per share are low so a high p/e represents an overpriced or expensive stock.

You would probably just want to buy companies that have a low p/e ratio right?

It means companies are cheap and the earnings per share are still pretty good. So why do people buy into a company with a high p/e? it doesn’t really make sense. paying a massive share price for a company that doesn’t even have very good earnings per share.

It is because in today’s day and age everything is online and we have access to information about companies. having a rough idea of where the company is going to be one to three years down the track.

The p/e ratio is nowadays less about finding cheap or expensive companies, it’s a way that can tell the general consensus of the outlook of a company.

p/e and investors today

What do investors typically think is going to happen with a particular company? everyone could just buy shares with a low p/e but they don’t. some people buy them with a normal p/e and others buy shares with a really high p/e.

A low p/e means overall that investors don’t really think that the company is going to be able to grow much in the future. they’re taking their money out of it, even though the earnings per share are good now, and the share price is really cheap.

We can look at it on the other end of the spectrum, if someone is paying for a company with a really high p/e ratio, they are anticipating that in the next few years the earnings per share is going to grow a lot.

those investors are paying such a high price for their shares, lead that the p/e ratio is becoming so high.

buying it because they anticipate that in the future the earnings per share will rise. that investment makes more sense.

The p/e ratio really tells you what people think about those different companies. it tells you about the overall market sentiment about that particular company.

Why p/e ratio is important?

Low p/e generally means that the company isn’t going to be able to do very much in terms of growth. high p/e means they are expecting big growth out of that company.

Let’s look for an example. Amazon is a company that right now has a p/e of about 105, remember that the average is around 16!

So having a p/e of 105 is absurd. people are paying a huge price as they are doing this because they believe that Amazon is going to really rapidly grow. their earnings per share in the future.

that earnings per share will be dragged up and then it will make that price seem a little bit more justified.

Overall p/e it’ll tell us what people think the future of that company will be.

When we’re picking individual companies, we might find through our research some companies that really have a strong core business, they have a wide moat, a nice strong competitive advantage.

Investor’s point of view

Sometimes when things start going wrong people frantically sell all their shares, and the increased selling activity can send the shares of great companies through the floor. so when it happens, we as investors, have to take advantage of this.

When great companies end up oversold they end up with very low p/e ratios, so for us as active investors we’re looking for companies that will offer us great returns into the future. Waiting until those companies do end up with a really low p/e.

Due to the irrational behavior of other investors,

and since investors are also just people who follow the pack, we’re obviously very emotionally acting beings.

So when stuff goes horribly wrong, most people just want to get out and sell everything to stop the pain. they want to stop their losses. when that happens what we should do?

we look for strong businesses that will be able to get through the tough times and will even maybe continue to grow. but when their share price is low that’s when we act.

so we actually do look for companies with low p/e ratios but we look for companies where we think the general consensus about a particular company is incorrect.

That’s kinda all about the p/e ratio I hope you found it valuable and you’ve learned something new.

Hope you enjoyed this see ya in the next post.

Check my previus post “What are the 5 different level of wealth“

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