A company's price-to-earnings ratio (P/E) measures the value of its shares in relation to its earnings. Calculating the P/E ratio is not complex. By using the following formula, you can easily calculate the P/E ratio of any company:
Current share price/earnings per share = P/E ratio
Imagine Company Alpha is priced at $30 while its earnings per share amount to $5. When you insert these numbers into the formula, the result is a P/E of 6. While there are more complicated calculations, this is all you need to get started. Also, most websites will include this number with the stock. Now, let us take a moment to look at the two sides of the equation.
What is a good P/E Ratio?
A low P/E ratio is often associated with stock being cheap (at least on paper), however, this may not always be the case.
A low P/E could be the result of temporarily high earnings driven by one-off factors (e.g. recent sales of assets) or an unsustainable earnings path (e.g. number of face masks sold during the height of the pandemic).
Even worse, the company might face a secular decline. Think of DVD rental stores that might have appeared cheap on past earnings some time ago but those earnings went to zero in a very short time.
To avoid such mishaps, it's best to check the forward P/E ratio, which reflects what analysts expect on the basis of a projected earnings trajectory. A word of advice: when making an investment decision, consider other metrics besides the P/E ratio as explained in our article on using the P/E ratio to invest.
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