some investors use financial statements
to create ratios that can help compare
the performance of similar companies
in this video you'll learn how investors
can use the p e ratio to help compare
the valuation of two or more companies
let's look at an example suppose there
are two companies that both make and
sell snow shovels
company a is trading for sixty dollars
per share while company b
is trading for ten dollars per share a
new investor might assume the ten dollar
stock is the best value because it's the
cheapest
but this isn't necessarily true a low
share price does not mean a stock is
undervalued
a stock is considered undervalued when
its price is low relative to the amount
of money the company earns
rather than compared to the price per
share of similar companies
to help compare these two companies and
determine which may be the better value
we need a common measurement such as the
price to earnings or
p e ratio the p e ratio simply compares
the stock's price to its company
earnings or profit
now back to our example let's say
company a
is located in wisconsin which gets a lot
of snow
therefore company a sells a lot of
shovels and earns a profit of one
hundred thousand dollars a year
company b is located in texas while
texas is a big state with a high
population
it doesn't receive much snow therefore
company b
only earns a profit of ten thousand
dollars a year we know each stock share
price in each company's earnings but we
don't know how many shares have claim on
the earnings
to put it another way we need to know
how many shares the company is issued to
calculate the value of each share
relative to the company's overall
earnings this calculation is known as
earnings per share
or eps because company a has fifty
thousand outstanding shares
and one hundred thousand dollars in
earnings each share has a claim on an
eps of two dollars
now that we have company a's eps we can
calculate the p
e ratio at a price of sixty dollars per
share and an eps of two dollars
company a's p e ratio is 30. this means
that stock is trading at 30 times its
earnings per share
let's calculate company b's p e ratio it
has 10 000 outstanding shares
and ten thousand dollars in earnings
resulting in an eps of one dollar
the stock is at ten dollars per share
which means company b
is trading at ten times its earnings or
has a p e ratio of ten
in this example company b may be a
better value not because it has a lower
stock price
but because it has a lower p e ratio in
other words
the lower the p e the less an investor
is paying per dollar of a company's
overall earnings
although the p e ratio is the most
common valuation measurement
it isn't the only indicator that should
be used when evaluating a stock
for instance some stocks may have low p
e ratios because they have limited
growth potential
if company b only sells snow shovels in
a state where there isn't much snow
then it isn't as likely to grow however
if both companies are expected to grow
at similar rates
then company b could be the better value
based on its p e ratio
also keep in mind that a high p e ratio
isn't always bad
for example suppose company a is doing
well because it invented a new shovel
that pushes itself
this new technology could increase
demand for shovels and the company could
grow very quickly
and potentially increase earnings this
kind of growth could justify
a high p e ratio in this case a high p e
ratio could indicate greater expected
growth opportunities
if you expect earnings to grow the
current price may be worth the
investment
the p e ratio is a commonly used and
versatile fundamental analysis tool
because it can help investors identify
value and growth stocks
just remember to compare price and
earnings and to keep earnings potential
and other factors in mind when
evaluating stocks
because the p e ratio only factors in
earnings per share
and price investors should consider
using other metrics like dividends or
projected future earnings
to help determine a stock investment's
potential
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