P/E Ratio Explained Simply - Trailing P/E and Forward P/E - YouTube

What’s up guys it’s Finest Finance here.

Are you interested in picking up the stocks by yourself, but don’t really know which

stock to buy?

I’ve already made a video where I show 10 important financial ratios, but today I wanted

to get a little more into detail about the P/E ratio, and show you how you can use it

to know if a stock is correctly valued.

If you find this video helpful, smash that like button to help my channel grow!

Let’s now get started with the video!

So what does the P/E ratio mean?

It comes from the words price-to-earnings, which means the price of the share divided

by earnings per share.

The price used is the market value per share.

For example if a share costs $10 and earnings per share are $2 the Price to earnings ratio

is 10 divided by 2, which equals 5.

But how can you know these numbers?

The current stock price can be easily found from different websites, like investing.com,

yahoo finance, google or whichever site you prefer to use.

This price shows you what you must pay for the stock at the moment, but the earnings

per share is a little more complicated.

There are two different variations for EPS, which are trailing eps for the past 12 months,

and an estimation of future earnings.

You can find these from yahoo finance for example.

Just go to finance.yahoo.com and search for the stock you want to buy.

Then go to analysis and there you can see past earnings per shares and the estimation

for the current year and the next year.

Remember that those are just estimations based on analysts, they aren’t always correct!

That is also the reason why some people prefer to use the trailing eps, because they don’t

trust analysts.

So why do we need to know those two different variations?

Because there are also two variations for P/E ratios, forward P/E ratio and trailing

P/E ratio.

The forward P/E ratio uses those future estimation earnings per share.

This means that you can compare the current earnings with the estimated future earnings,

to get a better picture of your investment.

The trailing P/E ratio uses the total earnings over the past 12 months.

This means that there is no estimations included, so this is the most objective P/e ratio.

While it is more objective and is based on facts, this doesn’t mean that it’s perfect,

because the past performance doesn’t tell us anything about the future performance.

The problem with trailing price to earnings is also the fact that the past EPS doesn’t

change, so if a company does something that makes the price of the share skyrocket, or

crash, the P/E ratio doesn’t really show that.

For example, if EPS is $2, and the price crashes from $20 to $10, the P/E ratio goes from 10

to 5.

Now it might seem like the company is undervalued, but what if the price crashed because the

company is not operating well anymore, and their future earnings are going to crash?

That’s one thing you have to consider with the trailing P/E ratio, but what else does

P/E ratio tell us?

First of all, if the forward P/E ratio is lower than the trailing P/E ratio, it means

that earnings are expected to increase.

For example, if the price of a share is $10, and the trailing earnings per share are $1,

the trailing P/E is 10.

However, if the estimated future earnings per share are $2, and the price of a share

is the same $10, the forward P/E ratio is 5.

As you can see, if the price of a share remains the same, and the earnings rise, the P/E ratio

becomes lower.

Secondly, the price to earnings ratio tells us how long it takes for your investment to

be paid back.

If you invested $10 and receive $2 every year, it takes you around 5 years to get that $10

back.

It’s also sometimes referred as the price multiple, meaning that how much you are willing

to pay for one dollar of earnings.

When P/E ratio is 5, it means that you are willing to pay $5 for $1 of current earnings.

The higher the P/E ratio is, the more growth investors are expecting from the company,

because they are also willing to pay more dollars to get that one dollar of current

earnings.

And thirdly, you can use price to earnings ratio to value the company.

It is one of the most used ratios for valuation, but how can you use it?

Well, it is mainly used to determine whether the stock is overpriced, or underpriced.

If the p/e ratio is high, it means that the price is high compared to earnings, so the

stock could be overvalued.

Or if the ratio is low, it means that the price is low compared to earnings, so the

stock could be undervalued.

The average P/E ratio is usually somewhere around 20, but this depends on many different

factors, for example different industries have different averages.

So one way to think is the company overpriced, is to check out what’s the average P/E ratio

for an industry, and then compare that to the price to earnings of a specific company.

You can also compare different companies with P/E ratio, if they are in the same industry.

For example if we have company A and company B that both are technology companies, if company

A has a P/E ratio of 10 and company B has a P/E ratio of 50, this means that the company

A would be a better investment according to price-to-earnings ratio.

There are also some special cases that I want to quickly show you.

What if the company's earnings are zero dollars, or they have negative earnings?

If the price of a share is $10, and the earnings are $0, this would mean that the P/E ratio

is 10 divided by 0.

If you put this to a calculator, you will notice that it’s not possible to divide

with zero, meaning that you won’t be able to use P/E ratio if earnings are zero.

If the company has negative earnings, it means that the P/E ratio is also negative.

If you divide 10 with -2, the answer is -5.

This doesn’t really tell us anything useful, just the fact that a company is losing money.

To analyze companies with negative or zero earnings, you must use other financial ratios.

You can check out my older video in the top corner for 10 different financial ratios.

Even when the P/E ratio is positive, I suggest you to take a look at other financial ratios

to analyse the company more deeply, to know whether or not it’s worth buying.

Price to earnings ratio is a great tool to check whether or not a company is correctly

valued, but it still doesn’t tell you everything you need to know before investing.

Now that you know how to calculate Price to earnings ratio, I have great news for you!

Since you are most likely using some investing websites to know the earnings per share and

the current price of a stock, you can also find the P/E ratio already calculated there!

But it’s great to know where those calculated numbers come from.

Let’s quickly take a look at the main points of this video.

P/E ratio comes from the words price to earnings The price is the current price of a share,

and earnings means the earnings per share The earnings per share have two variations:

trailing eps for past 12 months, and estimated earnings for the future, these can be found

from different websites Because there are two different variations

for earnings, there are also two different variations for the P/E ratio, forward and

trailing P/E ratio P/E ratio can be used for many things - it

tells you how long it takes for your investment to be paid back, how much you are willing

to pay for one dollar of earnings, is the company correctly valued and most importantly,

how to smash that like button!

If the earnings are zero or negative, use other financial ratios to analyse the company

Thanks for watching, share this video if you find it helpful, and check out my other social

media platforms shown on the screen!

Have a great day, I’ll see you in the next video!