When you’re hunting for a good bottle of Shiraz, there are many things you may take into account: the origins of the grapes, the year it was harvested, and the price compared to other wines on the shelf. But sometimes it’s difficult to decide which bottle of Shiraz has better value.
Investors have the same problem with the stock market. Luckily, a bright spark came along and invented the P/E ratio – making our lives so much easier. In a nutshell, the P/E ratio (price-earnings ratio) is the ratio of a company’s stock price to the company’s earnings per share. In simple terms, the P/E ratio would tell you how many years it would take for the company’s earnings to match the current price of its shares.
For example, a company whose shares are trading at $2 and has earnings per share of 10 cents has a PE ratio of 20.
– 200 (cents) divided 10 (cents) = 20
Why is this important? A high P/E ratio score suggests that it has high growth potential, whereas a low P/E ratio score would indicate that growth is slow. It’s not always absolute, but is a good rule of thumb for new investors. The ratio can be worked out via a simple equation or can be found on the stock exchange website.
Tips and tricks
Remember P/E ratios can vary wildly between sectors and industries. This is due to the different ways and timelines companies earn money.