Using the Price to Earnings Ratio to Value Stocks and Shares

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Image result for Stocks and SharesWhat is the Price to Earnings Ratio,
The Price to Earnings Ration (P/E or PER) is one of the simplest and common ratios used in investing. It is calculated by dividing the share price by the earnings per share (EPS). Alternatively, you will get the same result if you divide the market capitalisation by the profit after tax.
This ratio will tell you how much you are paying for the amount of profit a company is making, but only in a single year. So if the P/E ratio is 10, then the priced you are paying for your share of the company is 10 times the amount of profit it is currently making in a single year. Another way to look at it is if all the profit was paid out as a dividend then, assuming profit and price stayed the same, you would receive all your money back in 10 years. However it is extremely rare that companies pay out that much in dividends.
How is it useful,
The P/E ratio can be used to value companies. If everything else were equal, a company with a P/E ratio of 8 would be much better value than a P/E ratio of 12. However it is never that simple.
Whilst there is no such thing as a ‘good’ or ‘normal’ P/E ratio, it is generally viewed that for a stable company between 8 and 12 is normal. Below 8 may mean that it is undervalued and so could warrant further investigation. However being lower does not always mean the company is good value, it may be that it is in long-term decline and profits are expected to drop. This will mean that the P/E ratio will increase next year, and the price is likely to fall.
On the other hand a P/E ratio over 12 is not always bad news. It may mean that the level of profit compared to the price is very low, perhaps that company had a bad year and so you are paying a lot for a relatively low-level of profit. But it could also mean that profit is expected to increase, and there the P/E ratio would move back into the ‘normal’ range. This is usually the case for small, high growth companies. You will see P/E ratio of 50 or 100 for some of these as their initial investment is expected to turn into huge profits in the near future. A high P/E ratio in this sense means that future profit is already reflected in the price, however it could still grow more than expectations, so it is not a reason to ignore that company, but further research should be conducted.
P/E ratios are most useful when compared between similar companies in the same sector or industry. So if you decide that the insurance sector is set to grow you may want to compare to P/E ratio of all the companies in that sector that you are interested in to see which is worthy of investment. Looking at P/E ratios on their own, or comparing to dissimilar companies is not very useful.
Conclusion
As with all ratios P/E should not be used alone, instead it should be used in conjunction with other ratios and should be compared to other companies in a similar market.

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