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Considering the Price-to-Earnings Ratio When Investing

The price-to-earnings ratio or P/E (sometimes referred to as a multiple) indicates how much investors are willing to pay for each dollar of profit they stand to earn per year. For example, if an investor buys a stock with a P/E of 15, he’s willing to pay $15 for each dollar of profit, or 15 times the earnings for one share of stock. Another way to look at it is that it will take 15 years to earn back your investment in company profits.

The P/E ratio is a good criterion for checking a stock’s value relative to the broader market and its competitors. Use the following guidelines to establish your minimum requirement for purchasing a dividend stock:

  • Below the P/E of the S&P 500 Index: The rule of thumb is to look for stocks below the P/E of the S&P 500 Index, which averages around 18.

  • Below the industry’s average P/E: If your stock has a high P/E, compare it to the P/Es of its competitors and the industry sector as a whole. If a company’s P/E is higher than that of its competitors, the stock is probably overvalued.

  • Notable exceptions: Faster growing industries have higher P/Es, so don’t automatically discount a stock with a P/E over 18 — it may still be a good value stock. Many of these growth stocks are smaller than the ones on the S&P 500.

A stock with no P/E means the company posted losses. You want to invest in profitable companies to ensure the stability of the dividend payment. Stocks with P/Es higher than 20 means investors are willing to pay more for $1 of profits because they expect profits to see significant growth. Stocks with P/Es higher than 40 are expected to see very strong growth, but typically that level of P/E means the stock is just overvalued. Stocks with no or excessively high P/Es are speculative buys, not investments.

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