Understanding the Price Earning Ratio of a stock

Understand financial ratios and their relevance to stock market trading:

First of all, let's take a few moments to better understand how financial ratios are useful for your stock market investment activities. To do so, remember that financial analysis by stock market comparisons is currently one of the preferred methods used by analysts and that analysts use these ratios to determine their objectives for the price of a security.

This method is indeed more dynamic and more global than the others to evaluate the valuation of listed companies by stock market comparison. The use of ratios provides a more accurate assessment of the value of a share and therefore makes it possible to anticipate future share movements.

However, if you are interested in analyzing ratios, you may find yourself baffled by their very large number. This is why some of these ratios will be favoured, of which the PER or Price Earning Ratio is the best known.

What is the Price Earning Ratio or PER?

The P/E ratio is therefore the most analysed ratio on the stock market. It is a basic multiple that makes it possible to assess whether a security is expensive or not and is expressed as a ratio between the stock market price and net earnings per share or between market capitalisation and net earnings.

This P/E indicates the number of years of earnings that the investor is willing to pay when buying a security. When the P/E calculated at the end of the year is lower than in the previous year, it indicates that profits are increasing. If not, it indicates a risk that profits may fall.

The Price Earning Ratio will be particularly useful to compare several values with each other, but care should be taken to ensure that the calculation is not made when the company was loss-making in the previous year. This ratio should be compared to its historical levels or to the levels of the sector in which the company operates.

It is therefore understandable here that the PER, although it does not of course allow us to predict precisely the direction in which the share price will evolve, makes it possible to know whether a share is overvalued or undervalued, or even valued at its fair value. This makes it easier to find the cheapest shares to buy and the most expensive shares to sell.

Advantages and disadvantages of the PER for the valuation of a share price on the stock exchange :

Let us now look at the various advantages and disadvantages of the PER in the context of assessing the value of a share.

On the downside, the Price Earning Ratio does not take into account the nature of the industry and the effects of inflation. Indeed, if the nature of a sector of activity is not taken into account, it becomes useless to compare two companies operating in the same sector. Moreover, when inflation is high, companies tend to increase their prices in order to increase their profits and, in the case of low or no inflation, the trend will be towards lower prices. At the same time, these companies tend to underestimate storage costs and depreciation costs due to rising inventory renewal prices. As a result, the RIP is often driven downwards.

However, the PER has the advantage of being easy to calculate, although it is recommended that this calculation be carried out over a significant period of time, taking inflation into account. It can thus be concluded that this ratio is an interesting indicator that provides quick and relatively reliable signals but should by no means be used on its own. Indeed, the valuation of a share price through the Price Earning Ratio is not an end in itself. To respond effectively to this shortcoming, you can therefore use other financial and stock market ratios in parallel.

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