- To be able to properly gauge the potential of the stock, there are various financial metrics that need to be understood before even investing in the stock market.
- To begin with this, the 3 most vital ones are Price-to-Earnings (PE) ratio, Earnings per Share (EPS), and Return on Equity (ROE).
- They are extremely useful in analyzing the profitability of the company, its value, and its financial standing.
Price-To-Earnings (Pe) Ratio
What is a PE ratio?
- The PE ratio is the value metric of the company, which is used to determine its stock price versus the earnings per share of the company.
- A company with strong growth prospects frequently has elevated PE ratios, as it will indicate that the investors are willing to pay extra for the earnings of the company.
- On the other end of the spectrum, low PE ratios can indicate that the stock of the company is undervalued or that it is dealing with financial problems.
How does PE ratio help in stock selection?
Growth vs. value investing
- Investors who are focused on growth will favor the stocks with the high PE ratio because they will expect future earnings growth.
- Value investors, on the other hand, will focus on the stocks that are affordable with the low PE ratio because they expect appreciation in their share value.
Industry comparison
Adjusting the PE ratio of the company with that of the industry will indicate whether the stock is overvalued or undervalued.
Market trends
A consistently high PE ratio is a pointer to overvaluation, while a low ratio may be a window to buy a stock.
Earnings Per Share (Eps)
What is EPS?
- EPS is the proportion of earnings allocated to each of the outstanding shares of a company.
- It is usually calculated for the reporting periods.
- Higher earnings will mean higher attractiveness for investing.
How does EPS help in stock selection?
Growth potential
A continuously increasing EPS will indicate that the company is growing and its profits are also increasing.
Comparative analysis
The EPS of the companies in the same sector are compared to understand the position of the company in that particular sector.
Dividend insights
- Companies expected to be consistent in paying dividends to the shareholders are those that have a stable or increasing EPS.
- Such companies will not focus on selling the products but on building the customer loyalty.
Return On Equity (Roe)
What is ROE?
- ROE shows how efficiently a firm is utilizing the equity of the shareholder to generate the profits.
- A higher ROE will indicate that the company is efficiently using its equity capital to generate the profits.
Also Read: 7 candlestick patterns one should know before entering into the stock market
How does ROE help in stock selection?
Quality of management
Consistently strong ROE will suggest competent management and effective allocation of the capital.
Industry benchmarking
Assessing the ROE of the company alongside its rivals will indicate how well it is performing.
Sustainability of growth
- Firms that have high and consistent ROE are usually attractive candidates for long-term investment.
- This is because of their good financial and management strength.
Conclusion
The PE ratio of the stock will determine valuation, EPS will assess profitability, and ROE will evaluate efficiency. With all these 3 variables, investors will be able to make rational decisions and also create an optimal portfolio investment.
Frequently Asked Questions (FAQs)
Q1) What does PE ratio tell an investor about a stock?
The PE ratio will speak volumes about the investor expectations.
Q2) Why would investors intentionally choose stocks with high PE ratios?
They will expect these stocks to be less risky.
Q3) What is the most bullish scenario for the stock price of the company?
When its expected earnings are higher than expected and its PE ratio increases.
Q4) What is a good dividend yield?
12% is a good dividend yield.
Q5) Does ROE indicate profitability?
ROE will measure the profitability of a corporation in relation to the equity of the stakeholders.
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