It’s not easy to find a great stock. In almost every case, investors have already priced good and bad news about the company into the stock’s share price. But every once in a while, the market misprices a stock. So how do you find these hidden gems?
A company’s price-to-earnings ratio, or P/E, is one of the fundamental metrics that every stock picker should know. It’s is a great place for every investor to start when trying to find undervalued stocks to purchase.
How to Calculate a P/E Ratio
To calculate a company’s P/E ratio, simply divide the share price of a company’s stock with its earnings per share. (For an apples-to-apples comparison, be sure to calculate the ratio on a per-share basis.)
For example, if a company has a share price of $40 and earns a profit of $2 a share, its P/E ratio is 20. If the company’s price per share were to increase to $60 and its profits remained the same, it would see its P/E ratio jump to 30.
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P/E Ratio Shows You Companies’ Undervalued Stocks
P/E ratios are a leading indicator of undervalued stocks. A lower P/E ratio shows investors that a lower-priced stock is earning a larger profit. A higher P/E ratio indicates that a stock is more expensive or might not be earning a lot of profit when compared to the price of a share of its stock.
P/E ratios are relative, and should only be compared to those of other companies within the same industry or sector.
So, it isn’t fair or even accurate most times to, for example, compare the P/E of a technology company with that of a consumer products company, as these industries typically have different P/E ratio levels.
Technology companies frequently command a higher price for their stock, despite the lack of big profits. It isn’t unusual to see some technology companies with a P/E of 40 or more. Conversely, consumer staples and blue chip companies often have a lower P/E. It’s important to compare companies within their own industry to identify buying opportunities.
Disclaimer: I currently own shares of both Dr. Pepper Snapple Group and the Coca-Cola Company. I continue to purchase new shares each month using dollar cost averaging through both companies’ dividend reinvestment plans.