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A Beginner’s Guide to Value Investing: The PE Ratio

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So you’ve got some money to spare and you decide to invest it in the stock market. But what stocks should you pick?

There are several ways you can make your money work for you in the stock market such as stocks, mutual funds, ETFs, etc. However, it has been proven that the best way to create wealth is to invest in stocks. If you’re young, then you’ve got time and money to spare versus a person who is 65 and is nearing retirement. Now when you’re investing in stocks, there are a couple of strategies that you can use to invest in stocks. These include dividend investing, growth investing and the most famous, value investing.

Value Investing: A General Overview

Value investing was popularized by Benjamin Graham who was a mentor to Warren Buffett before he became famous. Graham wrote a great book called The Intelligent Investor. For those of you unfamiliar with value investing, value investing is investing in stocks that sell at a “discount” to the market. Think of it as buying your favorite shoe at a bargain and then selling that shoe to someone else for more than what you bought it at. Instead of chasing growth, you’re chasing value and looking for a bargain.

The P/E Ratio

One way to find out whether a stock is undervalued or not is to look at its P/E ratio. A P/E (price/earnings) ratio is the company’s current stock price divided by its EPS (earnings per share). The earnings per share can be the latest EPS reported by the company, or the forecasted future earnings. In either case, the earnings will refer to one year’s worth of earnings. It’s basically how much you’re paying for $1 of a company’s earnings. Low P/E ratios could indicate a company is undervalued while high P/E ratios could show a company is overvalued. If the stock is under the S&P 500 P/E ratio, then it might be undervalued. Here’s a link to check out the S&P 500’s P/E ratio right now: S&P 500 Ratio.

Be sure to also research the industry that the company operates in and find out its P/E ratio. While a stock may appear undervalued because its P/E ratio is lower than the S&P 500, it may, in fact, be overvalued according to the sector’s P/E. A good example of this would be utilities where investors are willing to overpay for the stability of these companies. Let’s look at one company to determine whether it is undervalued or not.

General Motors Example

Let’s take General Motors (GM). As of April 1st, 2019, it has a P/E ratio of 6.83 which is significantly lower than the S&P 500’s P/E ratio of 21.29. Therefore, we can say that GM might be undervalued and may be a value investment because it’s P/E ratio is significantly lower than the S&P 500. GM is a popular value stock because of its low P/E ratio and it’s owned by Warren Buffett which has increased its credibility as a value stock. Value stocks can bring substantial rewards but make sure to do your homework before investing in a company. Like any other investment, you want to do your research before making a purchase.

Conclusion

When you’re satisfied with the company’s fundamentals, find a fair price to invest in and hold on! Make sure to reinvest your dividends as well because those can dramatically increase your overall performance as well. Have fun investing and make sure to let me know how it goes down in the comments!

About the author

Co-founder and Managing Editor at | + posts

I am an incoming freshman at UCSD and I cover stocks, education, and the economy!