Value investors will use financial ratios such as price-to-earnings, price-to-book, and debt-to-equity to discover undervalued stocks.
The price-to-earnings ratio, or P/E ratio, is a metric that can help investors determine the market value of a security compared to earnings, showing what the market is willing to pay for a security based on either past or anticipated future earnings.
For an index, the ratio is calculated by dividing the total price of the stock by the combined earnings of all the companies included in the index. This indicator can help identify periods where the market is approaching “expensive” or “cheap” territory. A stock with a lower P/E ratio compared to its industry peers costs less per share for the same level of performance than one with a higher P/E ratio.
The P/E ratio seems like a straightforward calculation, but there are several caveats. A company’s earnings are based on either historical earnings or forward earnings, which are based on the opinions of Wall Street analysts. Earnings can be hard to predict, since past earnings don’t guarantee future results and analysts’ expectations have been known to be wrong at times.
Additionally, earnings are self-reported by each company, and accounting practices are not the same across the board.
A company with a high P/E ratio should not necessarily be dismissed either. The company could have high growth prospects and have just allocated a lot of its finances to growing its business, potentially making it a good buy.
Amid concerns of inflation and monetary tightening, the P/E ratio across all major indexes is currently down from a year ago. For example, the P/E ratio for the NASDAQ 100 Index, tracked by the Invesco QQQ ETF (QQQ ), was 34.01 as of February 11, compared to 40.12 a year prior. For investors who are bullish that large-cap growth stocks will rally, now might be a window of opportunity to add more exposure.
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