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One of the most popular ways at CAPEX to determine the valuation of a stock’s value and predict its future is the price-earnings ratio, or stocks p/e ratio.
At CAPEX, we offer plenty of tools to follow stocks with trading opportunities but until then, let us take you through how to calculate and use the price-earnings ratio at CAPEX.
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We are talking exclusively about stocks here. A stocks price-earning ratio, or stocks p/e ratio, is the ratio formulated for valuing a company that measures its share price relative to that of its per-share earnings. You may often hear this referred to as price multiples too. The price-earning ratio is used to determine the relative value of a company’s shares and the ratio is used by both investors and analysts. In fundamental analysis for trading, the price-earning ratio can be used to compare the company against its own historical data. A company needs to have earnings for the ratio to function – you can’t apply the price-earning ratio on a company that is losing money.
To calculate the price-earning ratio we only need to follow a simple process:
So essentially, CAPEX investors need to divide the current share price by the earnings per share value. The current share price can easily be located from within the market window at CAPEX. The earnings per share is an admittedly harder number to acquire.
You’ll find two variations of the earnings per share value. The first type is known as the “trailing 12 months” – or TTM on wall street – and it signals to companies’ earnings over the last 12 months. The second earnings per share type available to CAPEX traders is the company’s earnings release. The company’s release is an estimate on what the company expects to earn in the near future.
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A forward price-to earnings uses the guidance provided by the company to estimate future performance. It is a handy indicator of what earnings will appear like, free from charges and accountancy adjustments. There are some rather considerable limitations of this price-earnings method. For one, in order to beat the estimated price-earning, a company could very easily underestimate their earnings. Companies could also just as easily overstate their estimated earnings and then adjust it at a later date. Novice investors at CAPEX may also be confused as market analysts can also provide company estimates that can be different from the company’s estimate.
The trailing price-earnings relies on the 12-month metric that is generated by dividing current share price by the total earnings per share of the previous 12 months. At CAPEX, this is by far the most popular method for calculating price-earnings owing to its objectivity. Many investors do not trust an external estimate and prefer to use the trailing price-earnings. There is a limitation here though as well – and that is that future behaviour is not necessarily determined by past performance. We, at CAPEX, recommend only investing based on future earnings power rather than past success.
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Not only can the price-earnings ratio determine if a stock price is over or undervalued, it can also be used to compare a stock’s value within its industry – in fact, you can even compare the value against a major benchmark like when trading stocks in the S&P 500. At its core, the price-earnings ratio is an indication of the dollar amount an investor can expect to put into a company in exchange for 1 dollar of the company’s earnings. For example, a company may be trading on CAPEX at a multiple of x40, meaning an investor is happy to invest $40 for $1 of the company’s earnings.
This helps CAPEX investors determine the market value of a stock compared to its earnings. At the end of the day the price-earnings ratio represents what the market will pay for a stock based on either future or past earnings. So, a high price-earnings ratio could imply the share price is high relative to earnings and therefore overvalued. However, a low price-earnings ratio would signal the share price is low relative to its earnings.
To help out new traders at CAPEX, we’ve put together a quick example calculation of a price-earnings ratio. Imagine a stock price closed at a value of $81.09 and the company’s profits for the previous year was $15 billion. It’s number of shares outstanding for this scenario is 4 billion. That means the earnings per share is:
So therefore the price-earnings ratio is:
Many analysts that traders can follow on CAPEX make a distinction between absolute and relative price-earnings when producing a report.
The absolute price-earnings is calculated as the current share price and the trailing earnings per share amount or the next 12 months estimate. The relative price-earnings, however, compares the absolute price-earnings against a benchmark or past price-earnings – for example against the price-earnings over the last 5 years.
This will show what percentage of the past price-earnings has reached the current earnings – this measurement can tell CAPEX investors whether the current price-earnings has surpassed the older value or not. It is also important for CAPEX investors to remember that absolute price-earnings are based on the current time period.
Consider the price-earnings ratio of companies within the same sector to determine trends. For example, a high price-earnings ratio is less alarming if a comparison within the sector reveals a majority of high price-earnings ratios. Don’t forget to consider company debt, too – debt and leverage can alter price-earnings ratios quite a bit. Finally, it is important to really consider the source of earnings data. While the market determines the share price and the prices are reliable, the source for company earnings comes from the company itself. Analysts and CAPEX investors alike must trust that this data has not been manipulated – problems arise where that trust is broken, and that company becomes a considerable risk.
Also, sometimes traders need to think carefully about valuations by analysts too. They can sometimes be too optimistic about a hot stock during periods of economic expansion and have a tendency to be quite overly negative during times of economic lows.
Like fundamental analysis and technical analysis for trading, there are some limitations to using price-earning ratios too. It’s important for CAPEX traders to realise that no single metric is able to provide 100% insight into any investment opportunity. Companies that either are not profitable or have negative earnings cannot really be measured using this metric.
Another limitation is observed when using price-earnings ratios to compare companies. Growth and valuation can vary with such gravity depending on the industry or sector which makes it difficult to compare companies to each other. Price-earnings ratios also don’t really tell an investor much about a company’s potential for growth which can be misleading – for example, CAPEX traders may be willing to buy stock of a high price-earnings company if they were aware of the speed in which the company was currently growing. Finally, price changes in the market can also alter a price-earnings ratio dramatically in the short term.
Therefore, we, at CAPEX, suggest that price-earnings ratios should be used solely as a comparative tool within the same sector or industry. You can’t compare an electrical company with a mobile games company as the valuations and growth of the two industries are widely different.
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So you have completed your price-earnings calculations and made some comparisons, but not quite ready to actually trade with real money. That’s completely understandable and CAPEX have your back. Trade your comparison results using the CAPEX demo account – it’s free and there is zero risk. You can use CAPEX tools to identify stocks and perform price-earnings ratio calculations. If you like what you see you can invest virtually to see and monitor the results.
While no single ratio can tell you everything you need to know, the price-earnings ratio is a popular and reliable means of determining the true value of a stock. We, at CAPEX, can help new traders make the first calculations and teach traders how to compare stocks within their own sector and others. Despite some limitations, the price-earnings ratio has proven to be an effective metric when investing in companies within a single sector.
Traders who want to practice trading the stock identified through price-earnings calculations can use the CAPEX demo trading account for free. It is instantly available on sign up and really useful to see if you are applying the correct calculations to your price-earnings formulas.
Sign up to CAPEX today to learn even more about stock market trading and how to implement strategies such as using price-earnings ratios.