The P/E ratio is one important factor that could save you from making bad investing decisions. Here is your quick guide to Price & Earnings and the P/E ratio. I’m going to keep this simple, let’s begin with the only two definitions you will need for today:
Price: this is the stock price
Earnings: this is earnings per share; earnings are the amount of profit that company produces
Let’s take a look at a fictional company XYZ:
Company XYZ’s stock price is $50, therefore Price = $50
The company earned $5 per share, therefore Earnings = $5
Calculating the P/E ratio is easy, just divide the stock price by the earnings:
P/E = $50/$5 = 10
The P/E ratio for company XYZ is 10.
Basically this tells you that in order to buy one share of XYZ you are paying 10 times what the company earned:
10 x $5 = $50
If the stock price went to $200, the P/E ratio would be $200/$5 = 40
Remember the goal is to buy low and sell high. So in this example is it better to buy the stock at $50 or $200? $50 is a better deal, and you’ll be able to buy more shares at that price.
Therefore the P/E ratio is a really simple way to determine if you are paying too much for a company. Ideally when considering a stock for purchase I like the P/E ratio to be below 25, less than 15 is even better!
Let’s take a look at some real-life companies that currently should not be considered for purchase because their P/E ratio is too high:
There you have it, this one simple check could save you from making poor investing decisions. There are 11 other factors to consider before buying stocks which I cover in the Simply Investing Course, but at least you now understand how the P/E ratio can steer you away from losing thousands of dollars.
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