Finding Value in Earnings Announcements: How to Calculate a Price-to-Earnings Ratio
For many investors, earnings are the realization and confirmation of a company’s fiscal health and well-being, or an indicator of potential problems. Traders, analysts and experts alike often discuss price-to-earnings ratios (p/e ratio) and other factors when determining whether to buy, sell or hold a position.
The p/e ratio, price-to-earnings ratio, often referred to as “earnings multiple” or simply “multiple”, is simply the price of that stock divided by how much they earn. P/E ratios are not only stock specific, but certain types of companies and their respective sectors also posses p/e characteristics that investors use to measure expected performance.
For example, companies that are expected to grow at a fast pace, such as Amazon (AMZN), may command higher multiples going into their earnings reports. After earnings announcements, many investors hope the multiples will drop once news is released confirming the company made more money than expected. This is not always the case, however, as companies may disappoint investors by reporting weak sales or higher-than-expected costs. Disappointing earnings reports may lead to a sell-off in the stock.
As we head toward this quarter’s earnings reports, many investors will likely focus on the ability for companies to live up to any high multiple they are trading at currently.
Stocks in the SPX typically trade in a range of 14-17 times earnings (p/e) on average. Since we are so close to earnings season reports, the average p/e is almost 19 times earnings. If companies are exceeding expectations and making more money, that number will drop, allowing the market to move higher.
If companies do NOT continue to grow and make more money, that number could go higher, maybe causing investors to sell the index and bring that number (p/e multiple) to a more ‘realistic’ or ‘comfortable’ level.
The bottom line is that you should be aware of not only your company’s earnings dates, but also what p/e multiple they are trading at and what the rest of their peers and analysts expect from them. This can help you gauge whether the market perceives the stock as relatively ‘cheap’, ‘expensive’, or fairly valued.
No exact science exists for finding the perfect stock price or knowing what the market will do, but it does typically help stack the odds in your favor by buying companies that the broad market seems to perceive as less expensive versus overbought.
Please let us know if this explanation was helpful in the comments, or tell us what else you’re looking for as we move into this earnings season.
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