The P/E Ratio
The P/E Ratio
The P/E ratio, which is also called the multiple, is one of the indicators that fundamental analysts are using in predicting the growth and profitability of a stock and a company. Fundamental analysis is the analysis that is used by investors in measuring the stability and potential of the stock. Fundamental analysis involves examining the financial data of a corporation including its earnings, debt, expenses, EPS, P/E ratio and other important corporate information. For this article I would focus on how P/E ratio can be used to analyze a corporation.
The P/E ratio or the price-to-earnings ratio is the price of the stock divided by the EPS or earnings per share. There are two kinds of P/E ratio. The trailing P/E ratio and the forward P/E ratio. The trailing P/E ratio uses the most recent stock price as well as EPS of the corporation. The forward P/E ratio uses the most recent stock price and projected EPS of the corporation. Some analysts choose the trailing P/E ratio as they say it is based on facts and is more realistic than the forward P/E ratio. Others choose the forward P/E ratio as they rationalize that the profit is in the future therefore one should look to the future.
Considering that corporations vary in value as well as capital, it is very difficult to compare the profits of a $10 million worth of corporation and a $100 million dollar worth of corporation. A $3 million dollar profit for the former corporation can be considered as a good indicator whereas the same $3 million dollars would be a bad indicator for the latter corporation. That is why analysts created ratios and variables that would level all the corporations and enable the analyst to properly compare their financial data. The P/E ratio is one of those variables that can be used to compare corporations, regardless of capitalization or the worth of the company. One can compare the multiple (P/E ratio) of one company to the multiple of another company that is in the same industry. The investor would then find out if the stock price of the first company is inexpensive or expensive as compared to other similar companies. A corporation’s multiple can also be compared to the market multiple that is the multiple of the top 500 corporations. If the corporation’s multiple is higher than the market multiple then the corporation has a faster growth rate than the stock market.
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