Evaluating company stocks can seem overwhelming to those who do not have a background in finance. Yet, many investors utilize a simple method to evaluate the common stock of companies based on the price-earnings ratio (PE). This ratio gives investors a measuring stick to help them understand the relationship between the prices of different common stock issued by publicly traded companies.
The PE ratio is calculated by dividing the current market price of a stock by the earnings per share. If company XYZ is currently trading at $50 per share and the annual earnings per share are $2, then the PE ratio is 25. Since stock prices often change with new financial reports, PE ratios are subject to change, and are an aid in monitoring the growth or decline of a company's stock performance.
When using the PE ratio to determine the value of a company's stock, it is important to compare companies of similar quality that are already issued and publicly traded. The evaluation should also include comparisons of companies within the same sector and of similar size. PE ratios of individual companies may be used for evaluation of stock sectors itself or whole markets.
Market capitalization is the measure of the size of a company. Market cap is computed by multiplying the outstanding number of company shares by the price per share. Large cap stocks will have higher capitalization than small or mid cap stock. For comparison purposes, the PE ratio of large-cap stocks generally has less fluctuation than mid- or small-cap stocks.
When comparing the PE ratios of different stocks, carefully evaluate all aspects of the company, and take into consideration the fact that risky stocks often have higher PE ratios. A higher PE value does not necessarily translate to a better investment. Growth company stocks commonly have higher PE ratios than other companies.
Cyclicals, such as automobile companies, typically have lower PE ratios because they are based on market conditions. Since the average PE ratio for a company stock is 15, maintain extra caution when evaluating companies with very high or very low PE ratios.
PE ratios can be found in stocks charts published daily. The information needed to evaluate company stocks is accessible to anyone interested in the process. The simplicity of using PE ratios is available to those who take the time to research and remember to compare similar sectors and markets for analysis, while paying close attention to extremely high or low price-earnings ratios.