What is the P/E Ratio, Could it Save You Thousands?

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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:

  • Facebook (FB): 570
  • Zillow (Z): 7420
  • Netflix (NFLX): 632
  • LinkedIn (LNKD): 770

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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2 comments

Should You Buy Growth Stocks? | Simply Investing Dec 29, 2014 05:38am
[…] Should you buy growth stocks or avoid them? George Athanassakos (Professor of Finance at University of Western Ontario), discussed growth stocks recently in the Globe and Mail (August 26, 2014). Before I share with you the information from the article, it’s important to understand the P/E Ratio. […]
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What’s Your Biggest Fear in Investing? | Simply Investing Jul 18, 2015 06:27am
[…] dividends over the last 10 years (check the dividend per share values)? 4. Does it have a low P/E ratio? 5. Does the company have low debt (check the Long-term Debt-to-Equity Ratio)? 6. Is the […]
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