A popular ratio when looking at a company’s fundamentals is the price to earnings ratio (P/E), which is quantifying how much of a premium you are paying for the company’s profits.
Calculating the P/E ratio involves just dividing the current stock price by the company’s earnings per share (EPS), typically of the last 12 months. Value investors normally avoid stocks that pay multiples higher than 15 times earnings. However, trading at a low multiple does not automatically mean a stock is a good buy, as it could be trading at a low multiple because the company has no growth or has some other problems.
The more hype a company has and the greater the expectation of future growth there is, the higher the multiple to earnings that it will trade at. This is why tech stocks like Amazon.com, Inc.(NASDAQ:AMZN) can trade at three digit multiples.
In those cases, it becomes a bit less useful to use a price to earnings ratio since you would never invest in a growth stock if you did. Instead, what you can use is the PEG ratio, which divides the price to earnings ratio by the company’s average growth.
For example, Amazon’s P/E ratio is currently 249, and if we divide that by the EPS growth the company has averaged over three years (102%), the resulting PEG ratio of 2.4 tells us the share is still overpriced. A PEG ratio of less than one suggests the stock is a good buy, whereas a value over one means it is expensive.
