Why It’s Good To Understand A Good P/E Ratio For Stocks?

17th August 2020

When it comes to investing, stocks are among the most desirable investment options. Some people enter the stock market with a long-term vision, while some traders want to make quick money, capitalizing on the fluctuation of the stock price. A long-term investment is a stable method to make a good return on your investment from stocks.  

It’s easy to get your feet wet by purchasing stock in today’s era. However, there’re plenty of things you need to know before entering a stock market.  

You need to check out the company’s history, management team, macroeconomic condition, annual return, and various other aspects. One of the critical factors you must consider before choosing a company to invest is a price-to-earnings ratio.  

What Is P/E Ratio?

Price to Earnings Ratio (P/E Ratio) is the ratio calculated by dividing the cost of the stock by the earning per share (EPS). It helps investors judge the value of the stock and determine whether it’s wise to purchase the share in the current price.  

If investors find the stock has a good price-to-earnings (P/E) ratio, they get a green signal to proceed forward to a buying decision.

Here are some of the reasons why investors must understand a reasonable P/E ratio of a stock: 

Understand Whether The Stock Is Overpriced Or Underpriced

You would never want to pay more for the stock. The price of the stock keeps on fluctuating. At times, it gets higher than usual due to market demand, and it drops due to various reasons. Sometimes, the market price gets lower than usual due to bad news about the company.  

If you know the excellent P/E ratio for the specific stock, there’s a good chance you won’t be overpaying for it. If you want to make a wise decision, you should be updated with the latest news about the stock market.  

Here is an article about some of the best stocks to purchase in 2020, as per various experts.  

Use It To Compare With Other Companies In The Same Industry

There’s no such thing as a specific range to call a stock has a reasonable P/E ratio. Every industry has its different nature, and the characteristics of the industry dictate its P/E ratio. For instance, you will see a higher P/E ratio in companies within the healthcare industry, which could be in the rage of 30-35. On the flip side, companies in the energy sector trade at around 10-15 P/E ratio. 

Different factors determine a P/E ratio, and one of them is growth potential. You will usually see software companies trading at a higher P/E ratio because they expand quickly compared to other companies like a textile mill. 

However, it would be best if you kept in mind that companies trading at higher P/E ratios might have a higher risk. You will hear many technology companies losing a lot of money quickly, which doesn’t happen in other industries. 

Indicates The Future Performance Of The Stock

There are times when a specific ratio, which could be higher in the standard scenario, could be a reasonable P/E ratio. For instance, if there’s news of a specific technology company coming out with a revolutionary service or idea, it may trade at a higher than usual P/E ratio. A higher P/E ratio can indicate the future performance of the stock. 

If the management team is competent, and if the company is performing outstandingly, it will not be wrong to pay a little higher for a stock. You can get a great return on investment, despite spending a higher price. 

Is There A Limitation Of P/E Ratio?

Is There A Limitation Of PE Ratio

You shouldn’t entirely rely on the P/E ratio for making an investment decision. Every company follows its standards of accounting. And the company may also inflate the earning by hiding their costs or devaluating their liabilities. 

The consideration of the P/E ratio also depends on your risk-bearing capacity. If you don’t want to take a lot of risks, you may not want to purchase a stock with a higher growth possibility. There’s a risk associated with it. 

If you’re interested in getting a dividend, you should focus more on the company’s dividend rate. A company focusing a lot on growth won’t bother distributing a lot of profit. 

Final Thoughts

Understanding a P/E ratio for stocks will help you make a reasonable investment decision. With that said, there’s no objective answer to a reasonable P/E ratio for a stock. It depends on various factors like industry, earning potential, macroeconomic condition, etc. 

Purchasing a stock because of an attractive P/E ratio is good, but you should also look at its growth potential, management team, history, and other aspects that might impact the stock price. 

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