- July 5, 2020
Theprice to earnings ratio is a company’s current stock price over theearnings per share. It is used to calculate the market value of acompany’s stock by comparing the earnings per share and price pershare. Investors use the P/E ratio to predict the future value of thecompany’s stock. At times a company can have high or low P/E. thispaper will compare the performance of companies with higher P/E andcompanies with lower P/E.
Therefore,investors are faced with the challenge of choosing the mostappropriate company to put their money. The companies with futureearnings that are high are likely to have stocks that will appreciatein future. Investors are able to analyze how much they should partwith when buying stocks. A company with a high P/E ratio is anindication of positive performance, whereas, a company with a lowerP/E indicates poor performance in future. Businesses that have highP/E will have high average returns compared to those companies withlow P/E.
Giventhat the price earnings ratio is used to measure a company’sperformance, it means that a company whose P/E ratio is high willhave a high growth rate. A company with high P/E will perform betterthan a company in the same industry but with a low price to earningsratio. Companies that have a low price over earnings do not performwell in the stock market. Therefore, investors should stay clear suchcompanies. Such companies also have poor returns. Investors should doa thorough analysis before deciding to invest in a company with lowprice over earnings.
Investorsshould also not invest in companies that have a lower price toearnings ratio. Such companies are a poor investment and will notgive good returns on investment. However, investors can only chooseto invest in such companies if they have a fast growth rate. Apartfrom that, if the company is till new, then it has a high potentialfor future growth in as much as it may have a lower P/E ratio. Acompany that has been in existence for a long period of time may notbe so promising regarding future growth.
However,the price to earnings ratio is usually used to compare companies inthe same industry. Average price over earnings differs from oneindustry to the next. Companies that are in a stable environment,usually have lower P/E compared to companies that are just startingup. Therefore, when an investor is doing a comparison between twopotential companies, it is vital to look for industries that have thesame characteristics. In case an investor decides to buy stocks witha lower P/E ratio then such a stock will have a portfolio of similarcompanies. Such stocks are risky, and investors will lose money inthe end. Therefore, it is not worth parting with a huge sum of moneyfor stocks that have a lower price to earnings ratio.
Consequently,it does not mean that the stocks with a high P/E are definitely thebest investment choices. Such companies can still be an inexpensiveoption for stock investment. It is up to an investor to make acomparison and determine the stock that will yield higher rates ofreturn on their investment.
Whendoing a stock analysis on the P/E ratios, it is important to know theamount of premium to be paid. Additionally, it is crucial todetermine if the expected growth deserves a premium. It is alsoadvisable to conduct an analysis of the companies in the sameindustry to determine if the premium amount is worth the risk. Itwill be risky to pay a higher premium for a stock that is unlikely toyield higher returns.
Yes,the amount the investors pay as a premium is worth it. First becausefor companies that have low P/E, allows investors to buy stocks at acheaper price. However, the chances are slim of the return beinghigh. A majority of investors are after the profit achieved frominvesting in stock. In as much as investors are looking forinvestments with higher return, they should not pay premiums that arehigh above. Furthermore, very high rates of premium are notfavorable in sustaining an economy. The amount of stock can beoverpriced, and this calls for careful analysis before investing. Itwill not be wise to lose money simply because of making the wrongdecision.
Inconclusion, the price over earnings ratio is very important forinvestors. Investors who analyze this ratio carefully are guaranteedof getting huge profits on their investments. However, there aretimes when stocks can be overpriced and are not a representation of acompany’s future earnings.Both low P/E ratio companies and highP/E ratio companies have the potential to be good investments. Allthat an investor has to do is just make sure to do a thoroughanalysis of the company. Furthermore, investing in the stock marketis a worthy investment, but only if one invests in a company that hashigher expectations for future growth.
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Ou,J. A., & Penman, S. H. (1989). Accounting measurement,price-earnings ratio, and the information content of securityprices. Journalof Accounting Research,111-144.
Penman,S. H. (1996). The Articulation of Price–Earnings Ratios andMarket-to-Book Ratios and the Evaluation of Growth (DigestSummary). Journalof accounting research, 34(2),235-59.