There’s a lot of investing noise out there.  Chances are that you’ve heard a lot of jargon when dealing with financial professionals or listening to CNBC.  While it does offer useful insight to those in the know, they sometimes leave out what really matters.  The basic way of comparing two companies side by side.  Price doesn’t matter.  What really matters is the #1 formula in investing, the Price-Earning Ratio.

The Price-Earning Formula

The formula couldn’t be easier to remember since the name of it essentially describes itself.
Price
P/E = —————————-
Earning Per Share

This very simple formula is what allows investors to have an easy comparison between any number of companies.  The key is that it relates the earnings of the company to its current share price and gives you a ratio that is comparable no matter what the price of the stock is.

What You Can Learn From P/E Ratios

Once you have calculated the P/E ratios, or looked them up online, then you can start making some observations based on some general rules regarding P/E ratios.  To make it simple, here’s a list:
– Companies with more stable earnings will likely have a higher P/E
– A company with long-term expected growth will have a higher P/E
– When investor confidence is high, expect overall P/Es to be higher
– P/E ratios are inversely linked to inflation
– P/Es of companies or sectors are always examined within the context of the greater market or index in which they participate.

With these 5 things in mind you should be able to start your evaluation of a company and see where it stacks up in relation to its competition.  This is the most important thing to consider since no company operates in a vacuum, you must always evaluate a company based on its peers, as well as its own track record.

Find The Price In The Future

It is possible to find out what the expected price of the stock will be in the future by making one slight adjustment to the P/E ratio that is typically used.  For this case we need to rearrange the formula so that it looks like:

Price = P/E * Earnings Per Share

This requires you to have an estimate of what the P/E will be in the future.  You would get this number by estimating related information by using the 5 rules of thumb above and using the Forward EPS (Earnings Per Share) number that is typically provided by investment websites.

Let’s take for example that we know a banking stock will trade at 22 times earnings during strong economic times that we see in the future.  One particular bank, BigBonusBank Inc is expected to earn $4.50 per share next year.  We should expect this stock to be worth $99 (22 * 6.50) next year.

This is by far the most often used formula in stock market investing.  It is the best first step in comparing companies,  If you can develop your skills at determining future P/E ratios and therefore future prices of stocks you stand to make a lot of money in the stock market.  For more investing ideas visit the Canadian Penny Stocks blog.

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