What is the PE ratio?
This is an acronym for price-to-earnings ratio.
When looking at two companies, we need to know which one is better we used the common measurement to compare the two
Example:
Company A and Company B
A sells shovels and is located in a snowy area
B sells shovels and is located in a sunny area
A makes 100,000
B makes 10,000
A has a share price of 60
B share price of 10
now we need to calculate the earnings per share
A has 50,000 outstanding shares
B has 10,000 outstanding shares
So A has an EPS of
EPS = {100,000 \over 50,000}.And B has EPS of
EPS = { 10,000 \over 10,000}. Therefore: A has a P/E of:
PE = {60 \over 2} = 30.And PE of B is:
EPS = { 10 \over 1 } = 10 .A has a higher EPS than B. The conclusion we can draw from the EPS is that B is a better stock to buy because it has a lower PE ratio. WHY?
- because you are paying for the stock at a closer price to the earnings of said stock.
- buying A means paying £60 times for a company earning £2 per share
- and buying B means paying £10 for a company earning £1 per share
However:
P/E ratio is not the only indicator used when evaluating a stock, and for a good reason.
For instance, some stocks may have low PE ratio because they have limited growth potential.
I.e. company B selling snow shovels in a sunny area.
On the other hand, a high PE ratio is not always a bad indication, for instance, if A has invented a new type of shovel, this tech could increase demand for the shove,l and as a result, the company could grow quickly and increase earnings.
It would mean that, in this case, high PE ratio indicates greater expected growth opportunities.
So we would say that company A has high growth potential.
Take Away
- PE is a measurement of a company’s price to earning per share.
- the lower the PE ratio can be good for investors to maximise their buying power.
- low PE also indicate limited growth potential
- high PE can indicate high growth potential.
- all these are dependent on the company and what value they provide. so it would be wise to use other metrics like dividends and future earnings to make your decisions.
