Are Stocks Overvalued? Pro Investors Check This Number to Decide.
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Here's your money briefing for Monday, February 14th. I'm J.R. Whelan for The Wall Street Journal. When they're managing their stock portfolio or trying to boost their 401k, people often look to stocks, which have provided a higher return on their money than other kinds of investments.
How does the price-to-earnings (P/E) ratio explain whether a stock is cheap or expensive?
But a stock's price only tells one part of the story.
Just looking at the number of the price in a vacuum, that doesn't really give you enough information to know whether the stock is cheap or expensive. Just like, you know, you'd expect different prices for like a house compared to a dinner.
Coming up, we'll spend a few minutes in the stock market classroom with our markets reporter, Karen Langley. She'll explain a key metric that professional investors use to decide whether a stock is over or undervalued. That's after the break.
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The recent sell-offs in the stock market might make individual investors think twice about buying in. But often the signal as to whether stocks are a buy or a sell can be found not in the market's overall moves every day, but in a piece of data that professional investors monitor and one that many everyday investors often overlook, the price-to-earnings ratio. So what is that? And what does it tell us about the current market? WSJ Markets reporter Karen Langley joins us for a little Stock Market 101. Karen, thanks for being here. Thanks. So, Karen, just to get us rolling, can you explain what a stock's price-to-earnings ratio is and why professional investors care about it?
The P-E ratio, or price-to-earnings ratio, is a way to get a quick snapshot of how expensive or how cheap a stock is looking, usually compared to its own history or to companies in a similar industry. This ratio looks at the earnings that a company either has produced or is expected to produce and then compares that to the stock's price. Just to give an example, if a company is expected to make a dollar per each of its shares the next year, you might be deciding, is that worth $20 to you for that share or maybe $10 for that? And of course, when you're buying that share, you're probably thinking you're having more of an investment than just that next 12 months of earnings. Now, generally speaking, if a stock has a low P-E ratio compared to history or its peers, that would suggest to an investor that it's relatively cheap and might be a good investment.
Professional investors find this kind of information attractive because a stock is only going to produce a good return for them if they're buying it at a favorable price.
Okay, now let's say I'm looking at stocks to add to my portfolio and I see one that seems expensive, you know, maybe a few hundred dollars per share. If it has a low price-to-earnings ratio, it can actually make that stock look inexpensive. Why is that?
So the idea behind this is that just looking at the number of the price in a vacuum doesn't really give you enough information to know whether the stock is cheap or expensive, just like you'd expect different prices for a house compared to a dinner.
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