What is a P/E ratio?
P/E stands for the price to earnings.
This is calculated by dividing the market value price per share by the company’s earnings per share or EPS.
EPS is the company’s profit this is given to each share that is outstanding. Another way of saying this is the company’s net income per share.
Both of these are core fundamentals and need to be paid attention to.
How do I use the P/E ratio to analyze a company?
Overall Use: It should be noted that p/e ratios need to be compared to other stocks in the same industry. Each industry tends to have its own average, with the overall market having its own as well.
Overvalued: If you see a stock with a high p/e ratio there could be a multitude of reasons. If you see large net income and revenue growth this is pricing in future value and can be seen as a bullish sign. Using a forward P/E ratio in this instance will help make this clear.
Undervalued: If you see a low P/E ratio relative to its industry, you must look for the reason. It could be slow earnings growth, a bad political environment, government regulations, etc. Understanding the underlying reason will help you determine if it is fairly valued or actually undervalued.
Forward P/E Ratio
Same formula as the normal P/E ratio, but this uses forecasted earnings to predict the future P/E Ratio.
I like using the combo of the two to determine the direction of a stock.
If the forward p/e ratio is higher than the current, this can be considered bearish and show contraction in the stock.
Inversely if the forward p/e ratio is lower this can show growth and can be taken as a bullish sign.
It should also be known that since forward P/E ratios are based on projections they need to be taken with a grain of salt as they are still subject to change.
Combining P/E and Forward P/E
Signs to buy:
1. Forward P/E is lower than P/E
2. P/E ratio is lower than the industry
3. Earnings Growth
4. Revenue Growth
5. Debt to assets is low or manageable
Signs to Sell/Short:
1. Forward P/E is higher than P/E
2. P/E ratio is Higher than the industry
3. Earnings decline or negative earnings
4. Revenue decline
5. If a company is burning cash, this can be a sign of a need to do a share offering, which will dilute the stock.