Did you know only 5% of investors make money in the stock market?
Often, people lose money in the stock market because they don’t know how to identify companies with a promising future. Luckily, if you understand something known as the ‘price to earnings ratio’ (P/E ratio), spotting promising companies is much easier.
Read on, and you’ll learn more about this concept and why it matters when you’re investing in a company. If you want to make sound investments, you’ll soon learn how the P/E ratio concept can help you avoid disastrous decisions.
Let’s begin!
What Is a Price to Earnings Ratio?
P/E ratio sounds like a complicated and scary concept, but it’s quite easy to understand.
In basic terms, it’s used to determine how much money a company is earning in relation to each share offered by the company.
To calculate the P/E ratio of a given company, you take the market value of a share and divide it by the earnings per share.
If you’re worried about your ability to calculate this figure, note that most investing sites publish P/E ratios. That said, you can always verify things by typing the relevant numbers into a ratio calculator.
One good thing about a P/E ratio is that it gives you a simple metric you can use to compare companies.
For instance, once you have the P/E ratio of a particular company, you can then compare it to the P/E ratio of another company. You can then use this comparison to determine which company is the best investment option for your particular situation.
How to Interpret P/E Ratios
Now that you know what a P/E ratio is, you might have some questions about how you can interpret P/E ratios.
If a company has a high P/E ratio, it’s often a sign that a company is growing and will have a promising future. This might sound like a good thing, but this rapid growth can also represent a lot of risk.
Additionally, in some cases, a high P/E ratio can mean the stock price is overvalued. This is a problem, because the stock might then experience a huge drop if there’s a minor shock in the stock market.
If a company has a low P/E ratio, it often means the stock is underpriced, and thus there’s a good investment opportunity on offer. You’ll generally find that steady companies with a long history have a low P/E ratio.
Will You Make Good Investment Decisions?
If you understand the price to earnings ratio concept, you should be able to improve the quality of your investment decisions.
If you still have some doubts about the viability of this concept, you may want to try it out for a year. So, you might invest in two stocks that have varying P/E ratios, and you may make predictions based on what might happen.
At the end of the year, you can review your results, and determine whether this concept has actually produced reliable predictions.
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