Why the P/E ratio is extremely useful for investors in these times | Personal finance

(Stefon Walters)

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

The price of a stock by itself doesn’t tell you if it’s cheap or not. A $5 stock can be expensive, just like a $5,000 stock can be cheap. If some penny stocks were worth $5 a share, many investors wouldn’t hit them with a 10-foot pole. Whether Berkshire Hathaway Class A shares cost $5,000, they would probably be the most undervalued stocks in history.

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During bear markets, falling stock prices can sometimes cause stocks to “overcorrect” from more than their intrinsic value to less than their intrinsic value, leaving them priced favorably for value investors. However, investors should be careful when looking for stocks that are undervalued during these times, as it can be tempting to confusing low prices with low valuations.

This is why the price/earnings ratio (P/E) can be very useful in these unstable times in the market.

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Find the P/E ratio

To calculate a company’s P/E ratio, you first need to know its earnings per share (EPS). A company’s EPS is its earnings divided by its number of shares outstanding. For example, if a company has 1 million shares outstanding and makes a profit of $5 million, 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 a company’s EPS, finding its P/E ratio is easy: All you have to do is divide its share price by its EPS. If a company’s stock price is $100 and its EPS is $5, its P/E ratio would be 20. The P/E ratio tells you how much you’re paying for each dollar of earnings in a company. The higher the P/E ratio, the more you pay per $1 of revenue.

Read the P/E ratio

The most important thing to remember about a company’s P/E ratio is that it’s essentially useless on its own. To really To tell if a stock is undervalued or overvalued, you need to compare its P/E ratio to similar companies in its industry. You wouldn’t compare Nikethe P/E ratio of ExxonMobilbut you can compare Nike to under protection or ExxonMobil for Chevron.

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

If you compare similar companies and notice that one company has a significantly lower P/E ratio than the others, the stock is likely undervalued. If you are looking at a company that has a much higher P/E ratio than similar companies, it is likely overvalued.

There are limits to the P/E ratio

While it’s a great way to find undervalued stocks, the P/E ratio isn’t without its limits. For starters, the P/E ratio is usually calculated using a company’s past earnings instead of 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 with 100% certainty what a company’s profits will be until those future profits become a reality. An incorrect estimate could give investors the wrong picture of a stock, making it appear overvalued or undervalued when it is not.

Still, the P/E ratio has proven to be a great starting point for finding undervalued stocks, especially during a period of stock market volatility. It may not be a one-stop shop for determining value, but when it comes to investing, nothing is. For a single calculation, it manages to give a lot of perspective on a title, whether the times are hectic or calm.

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stefon walters has no position in the stocks mentioned. The Motley Fool owns and recommends Berkshire Hathaway (B shares), Nike and Under Armor (C shares). The Motley Fool recommends Under Armor (A shares) and recommends the following options: long calls of $200 in January 2023 on Berkshire Hathaway (shares B), short long calls of $200 in January 2023 on Berkshire Hathaway (shares B) and short calls from January 2023 to $265 on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

Robert D. Coleman