Why You Need to Understand P/E!
As you increase your vocabulary and understanding of the financial world, you will realize that P/E is one of those essential concepts to nail down. If you are new to investing, P/E is a financial metric known as the Price over Earnings ratio.
The simple metric allows investors to assess how much they will pay for each company’s earnings per share (EPS). It is an equation that shows the cost of a stock relative to its earnings. If a company has a P/E of 10, investors will pay 10 times the earnings per share (EPS) to buy that individual stock.
It is necessary to understand what P/E is because it provides the relationship between the price of a stock in correlation to how much an investor can earn from it. It assists in determining the value of a company, growth potential, risk assessment, investors’ perception, and how to move forward with investment strategies.
The P/E of a Lemonade Stand
Still not quite making sense? Imagine a young entrepreneur opens up a lemonade stand, and it becomes fairly successful. The owner, Jimmy, is considering selling it to an investor, Rebecca.
Before Rebecca buys it, she wants to determine the value of the business based on its earnings. At the same time, Jimmy wants to be aware of the same thing to ensure he gets a fair deal.
Jimmy’s lemonade stand generates an annual profit of $100, and he wants to use the P/E formula to determine her evaluation of the price she is willing to pay against the annual profit. Rebecca is willing to pay $300 for the lemonade stand.
P/E = Price/Earnings
P/E = $300/$100
P/E = 3
The lemonade stand has a P/E of 3, which means Rebecca is willing to pay 3 times the business’s annual earnings to own it.
Now because Jimmy’s lemonade stand has become prolific and his recipes are so tasty, another investor, Ron, also wants to purchase the company. However, Ron is a little nervous because he is still determining how much lemons will cost next year because of inflation. He is willing to pay $30 for the lemonade stand.
P/E = Price/Earnings
P/E = $30/$100
P/E = 0.3
With Ron’s valuation, the lemonade stand’s P/E is 0.3, significantly undervaluing the company’s profits, which leads Jimmy to clearly pick Rebecca.
Real-Life Example of P/E
Now let’s take this idea of P/E to the real world. If you look at Apple Inc. (AAPL), it is an infamous technology company. In May 2023, Apple demonstrated a dominating presence in the electronics industry.
In that month, Apple’s P/E was around 30, meaning investors would pay 30 times the company’s earnings per share (EPS) to own a share of Apple stock.
Hypothetically, if the earnings per share (EPS) was $10, and the P/E ratio was 30, investors were willing to pay $300 (30 x $10) for each share of Apple stock.
P/E = Price/Earnings
P/E = $300/$10
P/E = 30
Apple’s P/E in this example shows how investors assess a company’s earnings with its stock price. The P/E gives investors the perception of the company’s growth potential, risk assessment, and valuation, making it a high P/E.
Relation to Equities Lab
The powerful software provided through Equities Lab allows for this simple, yet important, financial metric to be applied when setting up a stock screener. It is one of many factors to evaluate varying companies, what to invest in, and what to consider in your continued learning journey through the articles and materials created by Equities Lab.