The Pitfalls of Using P/E Ratio in a Recession
Way back in the 1980s, a video game called Pitfall! had us searching for buried treasure in a virtual jungle. Fast-forward a few decades and we're still chasing that buried treasure -- only now, the search is happening in the real-life financial markets, and we're leaning on valuation metrics to point us in the right direction.
One of those metrics that can help locate hidden gems is the price-earnings ratio. Also known as price multiple or earnings multiple, the P/E ratio is derived by dividing the company's stock price by its earnings per share (EPS) over the last 12 months. The result tells you the price investors are willing to pay for every $1 of earnings. Investors use it to make comparisons between peers, and to gauge whether a stock is overvalued or undervalued. A higher P/E ratio could mean the stock is overvalued or that investors believe that the company's earnings will rise. A lower P/E ratio indicates that the company is either undervalued or that investors expect its earnings to fall.
Image source: Getty Images
Source Fool.com
