A low price-to-earnings ratio (P/E) indicates that the earnings on a particular share look attractive (on paper) compared to the market price of that stock. You can calculate this sum easily by using the following formula:
Share price divided by earnings per share = P/E ratio
As companies within the same industry tend to work in similar environments, it’s always best to compare the P/E to the average within that particular industry. For example, the retail industry had an average P/E of 20.54 as of writing, while the tech industry had one of 31. 50.
When you see a P/E ratio that looks low, remember to compare it to the industry average.
What does a low P/E ratio stock mean?
A low P/E can mean a variety of things. In an ideal situation, a low P/E means that the company’s stock is undervalued.
Of course, there are many limitations to using the ratio for investments. When the earnings are high, it can be a value trap, however. Companies tend to have cycles in which they do significantly better. For example, the auto industry and the mining industry are known for their cyclicality.
Is a low P/E ratio better than a high P/E ratio?
Yes and no. It’s very difficult to determine what makes a good P/E ratio. The market can be volatile and one-off factors may render a company unique from the rest.
The numbers can be misleading without context. An inflated P/E could indicate that a company is overvalued or that the company is predicted to do well.
When you are looking to invest and compare stocks, remember to gather as much information as you can. Context is king. It’s good practice to compare the forward P/E ratio (forecast) and the trailing (past) P/E ratio to the current figure to gain a deeper understanding of the state of the company.
Remember, most brokers provide P/E numbers on their websites, but if you want to dig deeper, you should go through the company’s presentations and earnings reports (to be found in the Investor Relations section of the specific company’s website). When you see a low P/E ratio remember that there is a lot more under the surface.
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