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How to Use the Price/Earnings Ratio to Evaluate Stocks

The prices earnings ratio (P/E ratio) of a stock is used for valuing a specific company. The prices earnings ratio is calculated as the stock price of the company divided by the company’s earnings per share. The prices earnings ratio of a company indicates the price the market is willing to pay for the earnings of that company.

Solid companies which have historically generated good earnings growth and have consistently delivered better earnings than forecasted are rewarded by the market with high stock prices and high P/E ratios relative to the rest of the sector’s companies. The stock prices of those companies will trade on a premium to its sector because the companies’ earnings are valued higher than the earnings of all other companies in the sector.

On the contrary, poor companies which have historically missed earnings forecasted and generated poor earnings have low stock prices, low P/E ratios and trade at discount to their sector. Poor companies are valued lower than the rest of the sector’s companies.

Prices earnings ratio formula

p/e ratio formula
Price earnings ratio formula

Professional traders use the company’s P/E ratio to compare a company’s performance versus the rest of the companies in the same sector.

Successful traders use P/E ratios to buy (go long) companies with the highest P/E ratios in a sector and sell (go short) the worst companies with the lowest P/E ratios in the sector.

It is wrong to use P/E ratio as a contrarian indicator to short companies with high P/E ratios or buy companies with low P/E ratios. There is a reason why the market rewards good companies with high stock prices and high P/E ratios and punishes poor companies with low P/E Ratios.

Price Earnings ratio and relative value

A P/E ratio can remain the same while the stock price drops consistently if the stock price falls linearly with the stock’s earnings.

Hence P/E ratios must be used on a relative basis to go long stocks with higher p/e ratios than the sector’s averages and go short stocks with lower p/e ratios than the sector average

We simply need to use current and/or forward P/E find out what the market likes and doesn’t like, why the market likes and doesn’t like it, and if there is nothing to disagree with what the market is telling us, then it becomes an idea.

Get relative p/e to each sector, and if in premium and discount there is a reason. Someone is prepared to buy it at premium or sell it at discount continuously.

You must know current p/e this year and forward p/e next year. Because when you get after Q2 then forward p/e becomes more relevant. You are looking 6-12 months ahead.

Nasdaq provides for each stock what research analysts are forecasting.

Price Earnings ratio notes

  • There is no such thing as “cheap” or “expensive” – it’s just perceived value.
  • the multiple of a company tells us the price that the market is willing to pay for the earnings of that company.
  • Price is a signal of quality. Therefore, the price that the market wants to pay for the earnings of that company tells whether the market believes the earnings are quality or not.
  • If a stock trades on a premium to its sector, it means earnings of that company are valued more highly than earnings of all other companies in the sector. There will be a reason for this and vice-versa on discount.
  • if you short stocks that trade on premium to their sector because you think they are “expensive” or you buy stocks on discount to their sector because you think they are “cheap” you are making the statement: I know something about this stock the market doesn’t know!
  • There is nothing you know that the market doesn’t already know!!
  • The market will stay irrational longer than you can stay solvent!!
  • The vast majority of the time the market is right. If you argue you are saying the market is wrong and you know something the market doesn’t know.
  • Don’t fight the market. Look at the valuations. The valuations tell you what the market thinks. It is signal of quality of earnings. Take information and search whether it is justified. If you think it is not justified think that you are fighting the market.

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