Many analysts and stock traders look at the price earnings ratio of stocks to judge value when buying. The PE Ratio is calculated by dividing the current market price by it's earnings per share. This is also known as a stock's multiple and a common financial formula.
When the raio is higher, it can indicate that a security is over priced, relative to other stocks in it's industry. While this should not be the only investment indicator a stock investor should look at, it is a true number - combining the real market price and the real earnings on a per share basis.
When someone says "We are only interested in stocks with low multiples....", they are focused on the Price Earnings Ratio. A company that is trading at $65 and has an EPS of $1.40, has an approximate PE of 46:1. This may or may not be a good ratio for a particular company. Some industries and sectors have historic low or high PE's.
Certain industries and stocks will value this number more or less. Start ups and growth companies are less concerned with Prices and Earnings.
In the end, investors should judge these ratios vs. companies in similar industries or type. A technology stock should not be measured against a utility company only on a PE Ratio basis.
- The price-earnings ratio, or P/E, is the most commonly quoted investment statistic, but have you ever considered what it actually means? For most people it's a shorthand way of deciding how highly the market regards a company, with investors prepared to overpay for earnings from a high-P/E 'glamour' stock as opposed to a low-P/E 'value' stock. However, academics have known since 1960 that the opposite is true: value stocks outperform glamour stocks consistently over decades. A company with a low P/E may have been marked down for no readily apparent reason and thus could represent an attractive value investment for those with the patience to wait while the market re-values it. However, the P/E is a backward-looking measure and just because the company earned £1 per share last year it doesn't necessarily mean it will earn anything like that in the foreseeable future. Or, a low P/E can mean a company is deservedly cheap because it is in financial difficulty - in this case the company is likely to become cheaper yet or even go into administration. This book is a practical guide to how you can adjust and improve the price-earnings ratio and use it, alongside other financial ratios, to run against the crowd and boost your stock returns.
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