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Although negative interest rates are a thing of the past for the time being thanks to the European Central Bank’s rate hike, persistently high inflation remains a challenge for savers. Because despite rising interest rates, classic savings investments such as call money and time deposits minus inflation will continue to make losses for the foreseeable future. Investors must therefore look for alternative investments to build wealth. In the case of negative real interest rates, stocks and ETFs are ideal.
But which ratios do you use to find suitable stocks? The so called Price-earnings ratio – P/E for short – is considered one of the most important ratios when analyzing shares. When it comes to securities trading, the first thing to do is to choose the right financial instruments. On the other hand, you must use key figures to assess the corresponding securities – for example shares.
Is P/E enough to value a stock? What does the price/earnings ratio say? In this guide, we explain what P/E is and the meaning of this ratio. We also show you how the price-to-earnings ratio for a share is calculated.
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What does the P/E (price-to-earnings) ratio mean?
P/E is a metric often used in fundamental analysis. Fundamental analysis is a method of evaluating stocks. This analysis aims to determine the fair value of a stock. P/E is a so-called multiplier which measures whether the company is valued more expensively or cheaper on the stock exchange. At least it gives you a first clue.
The P/E ratio sets the company’s profits in relation to the valuation on the stock exchange. The P/E ratio is therefore based on earnings per share and the market price. As soon as you regularly inform yourself about financial ratios, you will inevitably come across the international or English version: the price-to-earnings ratio. If you get information from international financial portals, look for it PRice-to-Earnings Ratio – P/E for short – Keeping an eye.
In the further process, we clarify whether and to what extent the PER or P/E ratio is sufficient for the valuation of a share. First, learn where the price-to-earnings ratio is listed.
Where is the P/E listed?
The price-earnings ratio is a well-established ratio that you can find on numerous financial portals. You can also check with your broker whether the price-to-earnings ratio or other ratios are available for a particular stock.
In the first step, retrieve a share of your choice using the WKN, ISIN or denomination. Many brokers provide you with a clear dashboard with key figures, company results, external analyzes and price data.
You can see the P/E at the following online brokers:
Neobrokers such as Trade Republic also offer an overview with key figures and price data. As a rule, the P/E ratio of a stock is displayed directly if you enter the following into the search engine:
- Company + inventory + P/E
You should pay attention to how the ratio between price and earnings is determined. There are different calculation methods. We will take a closer look at these methods in the next section.
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Calculate P/E: Formula for calculating the price/earnings ratio
As already mentioned, you can find P/E on several portals and with some online brokers. If you decide to calculate the P/E ratio yourself, that’s no problem either. You only need two pieces of information for this.
- Earnings per share (EPS)
- Current stock price
The formula for calculating P/E is:
- Price in relation to earnings = share price/earnings per stock
- Price to earnings = market value / net income
You can also find market capitalization data from online brokers or financial portals. The market value indicates the total value of all shares in circulation. You can find the year’s result in the company’s annual report. You can access this on the company’s website. Let’s consider an example below to illustrate.
Example of calculating the price/earnings ratio
Share X is currently quoted at a price of EUR 100 per share. stock. The market value is 100 billion euros. Company X has an annual profit of five billion euros. Earnings per share are five euros.
- Price in relation to earnings = market value/net income or share price/earnings per stock
100 billion euros/five billion euros or 100 euros/five euros gives a P/E ratio of 20.
Stock X’s P/E ratio is 20. However, there are several ways to determine P/E ratios. On the one hand, we can use the previous annual profit. On the other hand, the calculation can be based on the expected profit – a profit estimate.
Price-earnings ratio – Which calculation method makes sense?
You can use both past and future earnings to calculate P/E. There is no general answer as to which method is best. As is well known, the future is traded or priced in on the stock exchange. Therefore, the calculation based on the expected profit has its place. The prerequisite for this is that the expectation can be plausibly justified. Be aware of your source for how the price-to-earnings ratio was calculated.
Common mistakes when calculating P/E
Below is an overview of the most common errors in the calculation:
- The calculation is too pessimistic. You assume too little profit.
- Likewise, the calculation may be too optimistic because the profit estimate is too high.
- They do not use current data.
As a result, you may get a distorted result. Each key figure has its advantages and disadvantages and only a limited meaningfulness. Therefore, you should always use several ratios to evaluate a share.
What is the meaning of the price-earnings ratio?
P/E is a multiplier that indicates the relationship between the share price and the (expected) profit. You can therefore find out at which multiple of the company’s profit the share is currently valued on the stock exchange. A P/E of 20 means that the company needs 20 years to generate its market value as profits.
In this case, you will pay €20 for every €1 you win.
Both the profit and the share price change. As a result, this is only a snapshot. Can we now assume that a low P/E ratio is an advantage? At first glance, it appears that stocks with a low price-to-earnings ratio are cheap and therefore a good buying opportunity. Don’t be fooled.
Very low or high P/E – possible warning sign
A low P/E can mean:
- The share price has plummeted because the company is in trouble.
- Big wins are the exception, not the rule.
From this, it can be concluded that a low P/E ratio can even be a warning sign in certain constellations. Therefore, you should always look at the company’s overall situation. A low P/E ratio can of course also be a positive signal. A positive sign would be increasing profits with the share price constant. The company can sustainably increase its profits with innovations, and yet the price-earnings ratio is low. In this case, many market participants are still cautious – they do not yet believe in the success of the company. It can change at any time.
A very high P/E, on the other hand, can also indicate that the share is overvalued. Either the price has risen massively and the profit cannot keep up, or the price has stagnated and the profit has collapsed. Likewise, a constant profit with a simultaneous price increase could indicate that market participants are convinced of the business model and are therefore willing to pay a premium. In this case, the business is established and profit increases are hardly possible. Nevertheless, the market sees this as positive.
What is a reasonable price-to-earnings ratio?
There is no general answer to this either. When you look at a stock’s P/E, value alone says little. The next step is to compare the P/E with other companies in the industry. It doesn’t make much sense to compare the price-to-earnings multiple of a technology stock to the P/E of a grocery stock. Tech stocks tend to be growth stocks and consumer durables tend to be value stocks that don’t excel at strong growth. Therefore, you should always compare stocks within the industry and pay attention to the industry average.
Depending on the industry, a higher P/E ratio may be appropriate. A key factor in this regard is earnings growth.
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Expansion of P/E: Price/earnings relative to growth (PEG ratio)
The PEG ratio is a metric you can use to assess whether a stock is overvalued or undervalued. In the calculation, the P/E figure is set in relation to earnings growth.
How to calculate the PEG ratio
- P/E/expected earnings growth = PEG ratio
A P/E of 20 and earnings growth of 10 percent results in a PEG ratio of two.
What does the PEG ratio say?
The PEG ratio is a good indicator for evaluating high-growth companies. Growth stocks often have high P/E ratios – at least in the early stages. A high P/E need not be an exclusion criterion for investors.
Basically, a PEG ratio of one is a fair value. Consequently, a value above or below one is a possible over- or underestimation.
Let’s say that stock X currently has a P/E ratio of 50 and an earnings growth rate of 50 percent. As a result, the value of the PEG ratio is one – a fair value. Given the strong earnings growth, the high P/E ratio is reasonable. The prerequisite for this is sustained, strong profit growth.
In summary, this means:
- Neither a low nor a high price-earnings should automatically be interpreted as positive or negative.
- Compare P/E within the industry.
- Depending on the industry, a high P/E ratio may be appropriate.
- The PEG ratio is an important metric for evaluating growth stocks.
- When evaluating the stock, you need to pay attention to sustainable and stable earnings growth.
Several ratios are always required to evaluate a share. The P/E ratio alone is only meaningful to a limited extent. You should always look at the company’s overall situation. In a separate guide, we present the ten most important ratios that you can use to evaluate shares.