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Explaining P/E ratio
August 14, 2021
Breaking down an important principle, P/E ratio
We know that talking about investing and the stock market can sometime sound like an alien language.
The term, P/E ratio, is not any different sounding like jargon but it's actually a simple concept once we break it down.
First off, let's talk about the P/E, it stands for Price-to-Earnings. More specifically, price refers to the stock price of the share and earning refers to, well, the total earnings of the company divided by the outstanding shares. Note: outstanding shares means the total number of shares issued by the company which include shares kept within the companies and owed by the shareholders, us.
So for example, the company Good Food store has a stock price of $1. Over the past month, Good Food store earned $100 and it has 200 outstanding shares. So P or Price which is just stock price = $1. So for E or Earning, we take the $100 earned and divide it by the 200 shares, equalling .5. To finish calculating the ratio we have to divide P/E or $1/.5 which turns out to be 2.
So we are left with a P/E ratio of 2. Now what?
Well, it depends.
One number alone isn't enough to see the bigger picture. We have to look into different things such as the P/E ratio of other things in the market sector and the companies history. For example we have to look at Good Food store's other competitors, Excellent Cuisine and All-day Snacks, both are in the same market sector as Good Food, all being grocery stores. We will compare all of their P/E ratios to see if 2 is higher or lower than the rest.
We also have to look into the trends of the sector and stores to see what is the trend for P/E ratios. Once we know that, are we done? No and unfortunately there is no clear answer. Having a low or high P/E can mean a number of things. If it's low it could mean that the company's stock is discounted which is good or the company is failing which is bad. If it's high, it could mean that the stock is overvalued which is bad or having success which is good.
The P/E ratio is important to understand because it can provide crucial insights into a company's performance. Just remember, no single number can effectively tell the whole story. In the end, it's up to you to make the smart decisions.
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