Maybe you want to use your end-of-the-year bonus to start a stock portfolio but don’t know how to choose which stocks to buy? OK, maybe you don’t get a bonus, but you still want to take advantage of the market’s correction and get in when stocks are trading lower. Here are some tips on how to choose which stocks to buy.
The standard method to evaluate stocks, used by financial advisors, fund managers and small investors is the Price-to-Earnings ratio known as the P/E or PER. The P/E ratio helps investors determine the value of the price of a company’s stock as compared to the company’s earnings. This ratio allows an investor not only to evaluate a company’s profitability, but also to compare how an investment in a particular stock compares with other investments, for example Treasury bills, CDs, real estate or the stock of other companies. But, useful as it is, before you can use it, you have to understand it, which might take a little bit of focus.
Calculating the P/E ratio
Put as simply as possible, the P/E ratio is calculated by dividing the company’s stock price per share by the company’s earnings per share. For example, if a company reports earnings per share of $2 and the stock is selling for $20 per share, the P/E ratio is calculated by dividing $20 (the price per share) by $2 (the earnings per share) for a P/E of 10. Another company in the same industry might report earnings of $10 per share and is also selling at $20 per share. This second company’s P/E ratio is 2. If you are choosing which company to invest in, you are most likely going to choose the second company because you are getting five times the earnings for the same price, better known as more bang for your buck. The good news for non-math majors is that most financial advisors and investments apps will calculate this ratio for you.
Questions on the P/E answered here
The second question is which is better for an investor, a high P/E ratio or a low P/E ratio? The answer to this is not so straightforward. In general, a high P/E ratio is considered a better bet for investors because analysts have determined that the company’s earnings are expected to move higher. This, however, is not always the case as when a company “misses earnings,” which means its profits come in at less than what they expected. This usually results in their stock price falling.
The P/E ratio is only one tool that an investor can use to make investment decisions. It is most useful when choosing between companies in the same industry. Since you don’t usually have to do the P/E calculation yourself, you can put it in your arsenal along with other ways to evaluate what companies to invest in. But, if you have read this twice, at least you will know what people are talking about when they mention the P/E ratio.
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