One of the most common stock valuation methods is the Price Earnings Ratio or often referred to as PE ratio. The definition of the PE ratio is quite simple just as the name indicates: Take the current stock price and divide it over the earnings per stock.
So, as an example suppose stock A is currently at 15$ and its earnings mount up to 0.56$. The calculation of the PE then is: 15$/0.56$ = ca. 27.
It’s now important how to interpret this number. What does it tell me? What you will almost never read anywhere is what kind of unit this PE has. Most of the authors simply present us the bare number of the PE calculation. In order to know which unit you get at the end it’s important to know what you use in the beginning of the calculation.
And that is:
The price of the stock:
unit: $/stock
Earnings per stock and year:
unit: $/stock/year
If you divide $/stock over $/stock/year you will only get “year” as the unit of the calculated number. So 27 means 27 years. In other words: If company A continues to earn 0.56$ per stock each and every year it will need 27 years to reach the current stock price. That’s why it’s better to choose those stocks with a lower PE as they don’t need so much time to reach their current stock price.
Thus, the decision to make is: Buy those stocks with a low PE ratio.
That is ok, but what does “low” mean? Low, compared to the average PE of the same branch.
Therefore, the only thing you have to pay attention to is that you can only compare stocks of the same or similar branch when deciding to buy a stock based on the PE ratio alone.
The problem with the PE ratio is that the company must already earn something in order to use this PE figure. When it only generates losses (mostly the case with start-up firms) you can switch to the Price/Sales ratio because every company has at least a certain amount of turnover.
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Source: www.articledashboard.com
