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The P/E Metric
The ‘price to earnings ratio’ is a useful metric for evaluating relative attractiveness of a company stock price compared to this company current earnings. The required ‘net earnings per share’ information may be sourced from the relevant company financial reports, the financial press or your broker.
Different industries have different P/E ratio ranges that are considered normal for their industry group. For example, health care companies may sell at an average P/E ratio of 30, while energy sector companies may only trade at an average P/E ratio of 12 There are exceptions, but these variances between sectors and industries are perfectly acceptable.
They arise, in part, out of different expectations for different businesses. Tech companies usually sell at larger P/E ratios because they have much higher growth rates and earn higher returns on equity, while a a small miner, subject to dismal profit margins and low growth prospects, might trade at a much smaller multiple. From time to time, the situation is turned on its head and may reflect overall market trends.
Common Sense Investing Using P/E
The important thing to remember is that there is not a set rule you can apply. You must factor in what is going on in the world. For example, if the economy is in trouble or there is a global health crisis (like the Covid-19 pandemic we are experiencing right now), corporate earnings can be worse than expected. This lowers investor expectations, and stock prices will go down. Even if the market seems fairly valued at a P/E ratio of 14, bad times could cause the market returns to continue on a downward spiral with the P/E ratio going much lower.
On the other hand, during economies boom time, corporate earnings can continue to rise, and stock prices can increase for many years in a row. A P/E ratio of 15, or even 20, does not automatically mean the market is overpriced.
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