If you’ve ever turned on CNBC or Bloomberg TV, you’ve heard the talking heads say something along the lines of “This stock has a P/E of 15, while the S&P 500 Index has an average P/E of 20.” The price-to-earnings ratio (P/E for short) is a key fundamental indicator of whether a stock is undervalued or overvalued in relation to the overall market or its industry.
Price/earnings ratio explained
The price-to-earnings ratio is easy to calculate; it is the current closing price of the stock divided by its trailing 12-month earnings per share (EPS). Forward P/E is calculated by dividing the current closing stock price by the projected EPS for the next fiscal year; it typically uses analyst estimates or the company’s own guidance for earnings.
When a stock has P/E lower than its industry, it may be undervalued; price-earnings above the industry or index level can mean a stock is pricey.
P/E isn’t the be-all, end-all of fundamental analysis; it’s just one widely used and quoted indicator. When doing your due diligence, consider other factors, including fundamental ratios (price-to-book value, price-to-sales and more), industry growth, macroeconomic trends and more.
Of course, not every company can calculate a P/E ratio, for obvious reasons. Consider the case of Advanced Micro Devices (AMD), which recently had a trailing 12-month diluted EPS of -$0.54. Because AMD did not generate any earnings, its P/E is null. When a stock has a net loss — or simply breaks even for a period — there is no P/E to speak of. On the other hand, the semiconductors industry — which includes AMD — had an industry average of 23.9 over the same period; thus, it is fair to say that AMD could be overvalued compared to its industry.
The price-to-earnings ratio is widely used by fundamental investors and traders to indicate if a stock is overvalued or undervalued. Comparing company P/E to industry averages — in conjunction with technical and other fundamental analysis — can give an idea of how a stock might move next.
Jeff Bishop is lead trader at TopStockPicks.com. He runs short-term trading strategies, using stocks, options and leveraged ETFs.
You may also like
Exclusive System Tracks Wall St. Insiders
“Dollar Ace Simply Exposes Information That Wall Street Wants To Keep Quiet” Said Kyle Dennis
“One member, Wesley M., has already reported 360%+ gains in just a few short days. Don’t miss this!”
(Reserve Access Now)
“What Recession?!” Jason Bond nets $55,060 in realized profit in One Day
After going 6 for 6 on profitable trades recently, we caught up with Jason to ask how he did it.
Check out Jason’s exclusive interview revealing this tightly guarded strategy. (Watch Now)
RagingBull.com Co-Founder, Jeff Bishop, Launches High Conviction Trade Service
“We listen to our clients and we give them EXACTLY what they want, so we designed a service to deliver 1 trade, 1 time a week, with a 100%+ PROFIT TARGET, directly to your inbox every Monday before the market opens. (Read More)