Why the PE ratio is so important

Fsp Invest, 29 Jul. 2013

Tags: pe, pe ratio, price earnings, earnings, earnings per share, what is the pe ratio, why is the pe ratio important, profits, earnings growth, share price, relationship between profits and share price

The price earnings (PE) ratio is one of the most used share ratios in the investment world. The PE ratio can tell you if a share is overvalued or undervalued. And not just that, it doesn’t just ‘work’ for South African stocks, it works on a global scale. Read on to find out more about the importance of the PE ratio…

The price earnings (PE) ratio shows you the relationship between the price of a share and the profits the company is making.

But more importantly, the PE ratio tells you whether a share is cheap or expensive.

It could tell you where the share is going (and where the market thinks it is going).

In fact, if you look at this ratio correctly, you could see into the stock’s future, and see what the share price really should be…

The PE ratio tells you two of the most important things about a company, explains Francois Joubert, analyst of Red Hot Penny Shares

It shows the relationship between a company’s share price and its profits, hence its formula:

PE = Price/Earnings

That means it can give you an idea about the gains you can make based on the profit growth of the company. After all, the only reason to invest in a company is to make profits…

The relationship between a company’s profits and share price

When company profits go up, share prices go up. When profits drop so do share prices.

To help you understand its significance, we need to look at the relationship between earnings growth when compared to share prices.

There are period when earnings will overshoot the share price and vice versa. But an upsurge or correction in the share price almost always follows these periods.

And this pattern is the same for different countries. Whether you’re in South Africa, the USA or Japan in the long run share prices track the profits of companies.

There you have it, the importance of the PE ratio.

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