Question

Explain why investors look at a stock’s P/E ratio rather than its price to determine if the stock is cheap or expensive?

Answer 1

PE Ratio is one the most widely used ratios for determining whether a stock is cheap or expensively priced. It is calculated by dividing the current market price by its earning per share. This ratio tells you how much investors are willing to pay, in terms of a stock price, for the earnings a company produces. In this ratio, the company's current and future earnings are taken into account while deciding whether its expensive or cheap.  

Whereas on the other hand, mere current stock price becomes just a number when it comes to determining whether its cheap or expensive. It does not consider or indicate anything about the future potential of the stock nor does it help in comparing similar stock or the industry.

A high P/E ratio could mean that a company's stock is over-valued, or else that investors are expecting high growth rates in the future.In addition to showing whether a company's stock price is overvalued or undervalued, the P/E can reveal how a stock's valuation compares to its industry group or a benchmark like the S&P 500 Index.It helps in doing a apples-to-apples comparison.

Since PE ratio provides a better picture on the earnings potential vis-a-vis the current market price, Most analysts prefer PE ratio in finding out if a stock is overvalued or undervalued.