Have you ever had a similar experience like the following situation, where you purchase a kilogram of apples at $100 per kilogram, only to realize that you can also get the same kilogram of apple at $80 just a few meters away? Are you not upset at having to pay more for the same quantity and quality of apples?
The same thing is applicable to value stocks.
If you purchase a share from company ‘D’ for $100 and sooner find out that the share of company ‘E’, with likely better prospect for earnings is available for $60, would you not be bound to be disappointed.
You are bound to ask the following questions: How can I know if the current stock prices make sense? how do I find quality bargains? Does the value stock price justify the earning prospects of the company?
The answer to those questions is: Price Earning (PE) ratio.
Price Earnings ratio is one of the mostly used means of selecting value stocks . It is normally calculated by dividing the present stock’s market price by its earning per share (EPS). PE shows the sum of money that you are set to pay for each dollar worth of the company’s earnings.
PE = Market price / EPS
For instance, if there are two companies ‘D’ and ‘E’, running operation in the same sector. If the PE of ‘D’ is 40 and the PE of ‘E’ is 33, then ‘E’ is regarded to be a better buy, as the market price has not stepped up to show the company’s earnings prospects. But ‘D’ is regarded to display higher growth prospects as compared to ‘E’.
How can Price Earnings Ratio help?
A well understood PE ratio gives the investors an idea of whether the value stocks has adequate growth potential. Stocks with low PE ratio can be regarded as good bargains because their growth potential is unknown yet to the market.
If the PE ratio is high, it serves as a warning of an overpriced stock, meaning the price of the stock is much higher than the actual growth potential of the stock. So these value stocks are more likely to significantly crash. This warning will inform wise investors to sell off their stocks before its price crashes.