If you're new to investing then you've likely heard the term price to earnings ratio. What does it mean and how can you use it to help you become a better investor? 

Simply put, the price-to-earnings ratio is one of the most popular and simplest ways to calculate a stock's value. It is also commonly referred to as simply P/E. Many investors rely on P/E ratios when deciding whether or not a stock is undervalued, fairly valued, or overvalued.

Investors use price-to-earnings ratios for various reasons, such as forecasting future company earnings or comparing the P/E ratio of different stocks in an attempt to find undervalued opportunities. Here’s what to know if you’re just learning how to invest.

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What is Price-to-Earnings Ratio & How Does it Work?

Sometimes called the price multiple, P/E is calculated by dividing the company’s share price by its earnings per share. On some finance websites, you might see P/E (TTM) against a company’s stock. The TTM means “trailing twelve months,” which is essentially another way of indicating the company’s performance over the past year.

P/E, therefore, reveals to investors whether the particular stock is overvalued or undervalued. The metric indicates how much an investor may pay to receive one dollar of that company’s earnings. For example, if a stock is trading at a P/E of 30x, it means investors are willing to invest $30 in the company in order to earn $1 of the earnings.

Here’s another example. Company A has a price-to-earnings ratio of 5 while Company B has a price-to-earnings ratio of 20. So, you could make the case that Company A's stock price is cheaper relative to the company earnings while Company B might be considered more expensive. There are various reasons for this. For example, Company A might be a brand new company that’s in a high growth phase.

Why Do Investors Use P/E Ratio to Assess Investments?

Why do investors use a price-to-earnings ratio to assess investments? Great question! They use it to evaluate investments because price-to-earnings ratios provide a quick way to figure out how much money a company makes (the earnings) relative to its price.

Ultimately, this ratio measures a company’s current share price relative to its per-share earnings. You can use this to help you determine the real market value of a stock compared to what the company earns. In most cases, a lower P/E ratio is better.

Let's use an example to make it a little more understandable. Let's assume you recently started looking at buying stocks and decided to invest in two companies, Company A and Company B. Company A has a  price-to-earnings ratio (P/E) of 15.3 and Company B has a price-to-earnings ratio of 17.7. Which company would be the better investment for you? Well, according to P/E ratios, it'd be Company B because its price is lower relative to the earnings that it's making.

You can take this one step further and also look at the price-to-earnings-growth (PEG) ratio. With this metric, you’re taking the P/E ratio and dividing it by the expected annualized earnings growth rate over the next few years. 

Why? It helps you understand the specific growth rate of a company in relation to others that might be growing faster or slower. Overall, you’re looking to invest in companies that are fast-growing over the course of a few years. Typically, newer companies grow fast at the beginning and then the growth rate slows down a bit. Keep this in mind when evaluating stocks.

How to Calculate a Company’s P/E Ratio

Now, where do you find that information that will help you calculate a company's price-to-earnings ratio? You can find the information you need on any company’s current stock charts. While you can Google the name of the stock, we suggest visiting the Wealth Stack app here to view the most updated stock charts for the companies you’re looking to invest in. 

Then, you’ll need to calculate the earnings per share first. To do this, you’ll use the following equation:

EPS = (Net income available to shareholders) / (Weighted average number of shares outstanding)

However, you can often also bring up a stock chart or look at quarterly reports to check a company’s EPS as well. With that, you can now calculate the price-to-earnings ratio. Remember that it is calculated by dividing the price of a share of stock (the price it's trading for on the market) by its earnings per share (EPS).

Here's an example to make it easier to understand:

Let’s say Tesla’s current trading price is right at around $700. The last reported EPS was $1.41. With those numbers, you’d divide $700 by 1.02. That yields a P/E ratio of about 496. That’s pretty high! Currently, Tesla is actually reporting a P/E ratio of 383.86 which, quite honestly, is still pretty high. TTD, for example, has a P/E ratio of just 149.87.

Should You Invest in Companies with High Price-to-Earnings Ratios?

It’s not as simple as just looking at the price-to-earnings ratio to determine whether or not you should buy a stock. For example, a lower P/E ratio can sometimes indicate poor current and predicted performance. 

Likewise, what you’re really comparing a company’s P/E ratio to is the average P/E ratio of other similar businesses in similar industries. It’s not that helpful to compare the price-to-earnings ratio of Apple to a small, new construction startup that’s recently gone public, for example.

Ultimately, it’s more complex than simply calculating a price-to-earnings ratio and deciding to buy based on just that number. There are quite a few other factors that influence the overall viability of an investment.

To learn more about how to identify those as you grow as a beginner investor, download the Wealth Stack app today. It’s free and filled with lots of helpful videos about topics like these. We’ll guide you on your journey to becoming a pro investor. 

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