Why is the P/E ratio so beneficial for investors during these times | Smart Change: Personal Finance

(Stephon Walters)

Value investing is a strategy that can produce significant returns when done right. When investing in value, investors look for stocks that are trading below intrinsic (true) value. For example, if the intrinsic value of a stock is $100, but it is trading at $80, a value investor might invest, and one day the market price the stock correctly, then profit at least 25% from the increase from $80 to $100 dollar.

The stock price itself does not tell you whether it is cheap or not. A $5 stock can be expensive, just as a $5,000 stock can be cheap. If some cash stock is $5 per share, not many investors will touch it with a 10-foot column. if Berkshire Hathaway Class A shares were $5,000, probably the lowest in history.

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during Bear marketsA fall in stock prices can sometimes result in a stock’s “over-correction”, going from over-valued to under-intrinsic, leaving it at a competitive price to value investors. However, investors need to be careful when looking for undervalued stocks during these times, as this can be tempting. Mixing low prices with low ratings.

for this reason Price to Earning Ratio (P/E) It can come in very handy during these volatile times in the market.

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Finding the P/E Ratio

To calculate a company’s P/E ratio, you must first know earnings per share (EPS). A company’s EPS is its profit divided by the number of shares outstanding. For example, if a company had 1 million shares outstanding and made $5 million in earnings, its EPS would be $5. You can find a company’s profit on its income statement, which publicly traded companies are legally required to Quarterly file.

Once you know the EPS of a company, it’s easy to find the P/E ratio: all you have to do is divide its share price by the EPS. If a company’s stock price is $100 and its stock price is $5, then the P/E ratio will be 20. The P/E ratio tells you how much you’re paying for each dollar of the company’s earnings. The higher the price-to-earnings ratio, the more you pay for $1 in earnings.

Read P/E Ratio

The most important thing to remember about a company’s P/E ratio is that it is useless in and of itself. to me truly To get an idea of ​​whether a stock is undervalued or overvalued, you should compare its P/E ratio to similar companies in its industry. won’t compare nikeP/E ratio to ExxonMobilP/E ratio, but you can compare Nike to under the shield Or ExxonMobil chevron.

Some industries have naturally higher P/E ratios than others, so a cross-comparison is likely to be misleading. For example, banking is an industry known for its low price-to-earnings ratios. However, if you look at a construction company whose industry is known for higher P/E ratios, and notice that their P/E ratio is low, you might think it was the deal of the decade.

If you are comparing similar companies and notice that one company has a significantly lower P/E ratio than another, the stock is likely undervalued. If you are examining a company with a much higher P/E ratio than similar companies, it is probably overstated.

There are limitations to the P/E ratio

While it’s a great way to find undervalued stocks, the P/E ratio isn’t without its limitations. First of all, the P/E ratio is usually calculated using a company’s past earnings rather than its future earnings. The forward P/E ratio compares the current stock price to future earnings, but it is only an estimate; There is no way to know a company’s earnings for 100% with certainty until those future earnings become a reality. An incorrect appreciation may give investors the wrong image of a stock, making it appear overvalued or undervalued when it is not.

However, the P/E ratio has proven to be a great starting point for finding undervalued stocks, especially during a period of volatility in the stock market. It may not be a one-stop shop for determining value, but in investing, nothing. For just one calculation, it can give a lot of perspective on the stock, whether times are turbulent or calm.

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Stephen Walters He has no position in any of the mentioned shares. Motley Fool has and recommends positions at Berkshire Hathaway (B shares), Nike and Under Armor (C shares). Motley Fool recommends Under Armor options (A Shares) and recommends the following options: long January 2023 calls of $200 on Berkshire Hathaway (B shares), short January 2023 200 calls on Berkshire Hathaway (B shares), short January 2023 calls of $265 On Berkshire Hathaway (b shares). Motley Fool has a profile Disclosure Policy.

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