Smarter Investing in Stocks - Using P/E ratio in your decision making process

This year I have invested strong in stocks as a way to diversify my investments. While the crypto market disappointed me, I felt that I needed to invest in something that could provide a short term revenue channel, but also some long term growth opportunities. Thus, I have decided to build a stocks portfolio that are paying dividends from multiple markets as US, Europe and National. This way I could get some cash flow during the year, but also have the chance to earn significantly from the price appreciation. And I must say that for now I did pretty good with a ROI of around 15% year to date.

While my decisions were based upon the macroeconomic context and also trying to bet on some underdogs in emerging industries, I must say that I could have done better choices. How? Well, simply by considering more indicators in my decision making process like P/E ration. So next I will try to decipher what this is and how it can be used to make decisions using more information than news or trying to predict the market.

P/E ratio

The P/E ratio is the acronym for the Price-to-Earnings ratio which is the proportion of a company's share price to its earnings per share. A high P/E ratio could mean that a company's stock is overvalued or that investors expect high growth rates. But what is important in this equation besides doing the math is to compare it with other numbers in the same sector or even if index funds. This way if you choose a company, you can figure out where it is standing across the industry is producing for.

• For example if the price of a stock is $20 and the corresponding earning for 1 year is $2, that means a ratio of 10 or the fact that it will take 10 years to recoup the current value of the stock (or the one that you've bought into).

Beside the P/E ratio there are two other derived concepts that we can or should consider when analyzing a stock: Trailing P/E and Forward P/E. Both can provide additional insight or different view on the health of a stock and we can pick one or the other in the decision making process.

Trailing P/E ratio

The trailing P/E is the standard form of a price-to-earnings ratio and is calculated using recent past earnings. Thus, the Trailing P/E is calculated by dividing the current market value, or share price, by the earnings per share over the previous 12 months.

Forward P/E ratio

The forward P/E uses projected future earnings to calculate the price-to-earnings ratio. This means that the forward P/E ratio estimates a company's likely earnings per share for the next 12 months.

Cumulative calculations

It can be helpful for investors to consider both calculations of the P/E ratio. If an investor has noted the forward P/E ratio from the previous year, the investor can check to see how accurate the previous year's estimated P/E was based on the current P/E. Forward P/E calculations are also helpful in comparing the likely future performance of similar companies in the same industry.

Tracking all these indicators will show how accurate the estimations were done and they can be support for further decision. For sure it is not enough to know the evolution of a stock, but I think it can light some insight and offer more trust when making a decision. Up until now I wasn't looking at such details, but I feel that as my portfolio has grown quite a bit it is a must to do so. I will first need to write down for all the stocks in the portfolio all the P/E ratios (trailing and future) for the past few years and compare them with other stocks in the industry to see where I am positioning myself. And this can help me in the future optimize my portfolio and even make better decisions.

Posted Using InLeo Alpha