Are you looking at investing in the stock market?

Do want to toss aside conventional wisdom and pick your own stocks?

I understand. Sometimes you just gotta see if you can beat the market.

And sometimes you might.

There are people who do.

Before you jump in head first, you need to know what a price to earnings ratio or P/E ratio is.

And you need to know how to use it.

What is a Price to Earnings Ratio?

To start, let’s look at the Investopedia definition.

The price-earnings ratio (P/E Ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.

Hmmmm, that didn’t help as much as I hoped. Let’s look at an example.

On 3/29/17, Home Depot stock price was $147.00 and its earnings per share was $6.45.

You can find this information by Googling “Home Depot Stock Price.”

So to find the price to earnings ratio, you divide $147.00 by $6.45.

That gives you a price to earnings ratio of 22.79.

So back to our definition, the price to earnings ratio gives you an idea of how expensive a stock is compared to the income it’s generating.

22.79 is great and all but we need to know what that means and how we should apply it.

How Do You Use a Price to Earnings Ratio

Is 22.79 expensive? Is 22.79 cheap?

At this point, you don’t know. A fair price to earnings ratio is different for different industries.

A lot of it depends of perception of growth potential.

If the industry has a high growth potential, the price to earnings ratio will be higher.

If the industry has a low growth potential, the price to earnings ratio will be lower.

For example, 22.79 for a water utility company would be really high.

22.79 for a technology company would be really low.

So you need to do your homework.

For Home Depot, you would look up all of it’s competitors.

One competitor is Lowe’s so lets look at them.

On 3/29/17, Lowe’s price to earnings ratio is 23.75.

So 23.75 is higher than Home Depot’s 22.79.

So relative to Lowe’s, Home Depot is a cheaper stock.

There may or may not be a reason for that so you need to check the financial statements of each company.

But that’s a lesson for another day.

Summary

You can hit it big or lose your but picking your own stocks.

You can do all of the analysis correctly and still get it wrong.

It’s not easy getting it right but if you don’t have the right knowledge and tools, you don’t stand a chance.

So continue to learn and continue to get better.

Have you used the price to earnings ratio to buy a stock before?

If so, how did it turn out?

Let me know in the comments below.

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