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A helpful strategy to use when reviewing what a stock’s worth truly involves understanding the P/E ratio. This is the price-earnings ratio. This measurement shows what investors are willing to spend on a stock. When the total is higher, investors will expect to get more earnings over time. When the total is low, the stock is seen as being undervalued. This means the stock is trading at a value below what the perceived value might be. It could make for an intriguing stock to purchase thanks to how it is considered to be a slight bargain at this juncture.
The measurement for getting the P/E ratio:
The total value of the P/E ratio refers to how much value the stock market places on that stock. When the ratio is higher, the stock market values it more. That is, the stock is something people are going to want to buy.
Here’s an example of how the P/E ratio works. Going back to Macy’s, you might see that the stock is worth $26.26. Meanwhile, the EPS is at 2.28. This is based on the net income of $697 million being divided by the 304.57 million outstanding shares that Macy’s has. By dividing the stock value and EPS, we get a total of 11.52.
So, what does this example mean? It suggests that an investor would be willing to pay $11.52 for every dollar of Macy’s current earnings. This is a cheap total as it suggests people are not going to spend too much to invest in the stock. The low P/E ratio suggests that the Macy’s stock might be worth investing in if you are trying to find something a little cheaper on the market.
What If a Company Is Losing Money?
A company that is losing money will have an N/A mark on its stock report when you look at the P/E ratio. Although you could technically calculate a negative ratio to show that a company is losing money, it is easier to use the N/A listing as an indicator that people are not necessarily expecting to gain much from the stock based on its earnings. This might be a sign that a stock is too risky. It could also be a sign of a business possibly having undergone some expansion plan or legal issue that might cause it to temporarily lose money.
The best thing to do in this case is to find out why a company is losing money. Look at the prior performance of that company to see what its P/E ratio might have been during better times. Sometimes the P/E ratio might only dip briefly while a business is growing and will rebound back to its original value after those efforts are complete.
The Optimal P/E Ratio
The Macy’s example shows that the company is making money and is not struggling. Is a P/E ratio of 11 good? There are no real answers as to what the best P/E ratio for a stock is. If you are trying to find good value, aim for stocks with low P/E totals. A stock that trades at a few times its earnings may be cheaper than something that trades at 12 or more times its value.
Consider the P/E ratios of many stocks in the same industry. A stock in the technology sector that features a P/E ratio of 25 might be interesting, but another stock in the same industry with a ratio of 14 could be even more enticing.
Watch for Inflation
Be aware of what the inflation rate is when looking at the P/E ratio. This measurement is typically lower when the inflation rate is high. This is because the earnings of a business might be somewhat skewed. As the power of the dollar increases, it will appear as though a business is making more money. That increase is because more dollars are being factored into transactions. The replacement costs for assets are increasing just like the prices for other staples in the market.
Look at how the inflation rate has changed over time as you look at the historical data of a stock. Have you noticed cases where the P/E ratio has shifted dramatically? This could be due to the inflation rate changing quickly.
It only takes a few months for inflation to make a difference. In May 2015, the inflation rate in the United States was as 0%. In February 2016, that total went to 1%. It would become 2.1% in November 2016. It takes a few months for the inflation rate to make a sizable change, but that shift will be noticeable when you look at investments.
