P/E Ratio

P/E ratio definition

The P/E ratio of a stock is used for valuing a specific company. The P/E ratio is calculated as the stock price of the company divided by the company’s earnings per share. The P/E 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.

P/E formula

p/e 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.

P/E 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

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