Investors Need a Method to Their Madness: Analyzing Stocks with the P/E Ratio
Investors know that analyzing an investment is as diverse as the flavors of cake. Some prefer a simplistic vanilla approach while others prefer a more complex death by chocolate. However, regardless of personal preferences, it is important for investors to have a method to their madness when choosing stocks.
One such method is using the price-to-earnings (P/E) ratio, which can help investors determine if they are getting a good deal on a stock’s price. According to Ayako Yoshioka, a senior portfolio manager at Wealth Enhancement Group, “Stock prices can move around a lot, so having multiple ways to determine a stock’s value is important information when deciding to buy or sell a stock.”
The P/E ratio is calculated by dividing the current stock price by the company’s earnings per share (EPS). Terry Sylvester Charron, senior director of Family Wealth Investment Advisor Group at BNY Mellon Wealth Management, explains that the P/E ratio tells investors how expensive or inexpensive a company’s current price is based on its current earnings.
Most financial websites provide this data on stock analysis pages, so investors seldom need to calculate the P/E ratio themselves. However, if they prefer to crunch their own numbers, they can find EPS on a company’s income statement.
So, what does the P/E ratio tell investors about an investment? According to Andrew Crowell, a financial advisor and vice chairman of Wealth Management at D.A. Davidson, “The P/E ratio tells how much an investor is willing to pay for $1 of earnings of the underlying company.” For example, Apple’s P/E ratio is currently 29, which means investors are paying $29 per $1 of the company’s earnings.
The P/E ratio provides insight into how the market perceives the earnings potential of an investment. Companies with faster earnings growth potential and more sustainable earnings power tend to have higher P/E ratios than peers with slower growth and/or lower quality earnings, says Charron.
It is important to note that P/E ratios can vary by sector and tend to rise during bull markets and contract during bear markets. Crowell advises investors to keep this context in mind when analyzing P/E ratios.
Investors can use the P/E ratio to compare stocks to their peers or the market in general. Crowell explains, “If all other metrics are equal, an industrial stock with a P/E of 17 is more expensive than an industrial stock with a P/E of 13. If the two companies have similar growth rates, revenues, debt levels, etc., this implies that the higher P/E stock is more expensive than the lower.”
Choosing low P/E companies as an investment strategy can help investors avoid paying more than necessary for an investment. Crowell emphasizes the importance of buying stocks at the right price and having the discipline not to overpay.
Yoshioka suggests that investors can also look back at a stock’s history to see where the average P/E ratio has been and whether the current P/E is at a premium or a discount.
However, it is important not to oversimplify the power of the P/E ratio. Low P/E stocks are not necessarily safer than high P/E ones. “P/E is simply one measure of valuation,” warns Crowell. Yoshioka recommends considering additional forms of valuation, such as price-to-sales (P/S) or price-to-free cash flow (P/FCF), as a helpful supplement to the P/E ratio. Both of these metrics replace the EPS calculation with the company’s sales or free cash flow.
In conclusion, having multiple methods to analyze investments is crucial for investors. The P/E ratio provides insight into a company’s value, buying stocks at the right price and having the discipline not to overpay Crowell emphasized this point. Investors should consider other metrics and forms of valuation, such as P/S or P/FCF, to make informed investment decisions.
Analyst comment
Neutral news. The article explains the importance of using the price-to-earnings (P/E) ratio as a method to determine a stock’s value. It provides insights on how the P/E ratio can be used to compare stocks and make informed investment decisions. However, it also highlights the need to consider other metrics and forms of valuation. Overall, the market is expected to react based on individual investors’ preferences and their analysis of the P/E ratio in combination with other factors.
